Tax Issues in Family Law Property
settlements
DISTRIBUTING THE SPOILS ¾ THE DIFFERENCE BETWEEN HACKING AND
CARVING
(Updated to 22 July 2009)
This article is available in a convenient A5 sized
booklet format for ready reference. For copies ($25.00 inc GST) see Mooreslegal
Publications
Further (and in fact essential) reading - refer to the very comprehensive article by Queensland's Hopgood Ganim lawyers Alison Ross, (Family Law) and Luke Mountford (Business Services), dated 19 August 2006. It is entitled "Practical issues in property settlement matters: Tax and accounting for the family lawyer. The paper examines how the Family Court deails with the issues summarised below in considerable detail. Case law is provided for those interested in burrowing even deeper.
See also Superannuation Splitting under the Family Law Act explained. That article (updated to 16 October 2008) gives examples on what happens with superannuation under the revised Family Law Act which came into effect on 28 December 2002
Family lawyers involved in financial matters are really undertaking forced estate planning. As such, they and the financial experts also involved need to come to grips with the full ramifications of their work in this regard.This paper covers the strategies that need to be understood by family lawyers when negotiating a family law property settlement or formulating orders to be made by the Family Court. Accountants and financial planners may also find this paper of assistance when creating a financial plan for their clients. With care, the inevitable financial loss to both parties can be kept to a minimum, and unwanted revenue expenses can be avoided. For example, transfers of real estate pursuant to financial agreements under Section 90 of the Family Law Act (which replaced section 86 and section 87 Agreements as from 28 December 2000) did not attract CGT rollover relief until 12 December 2006. This is despite an announcement in the May 2005 Federal Budget that they would. Royal assent was slow in coming. Failure to take such issues into account can have disastrous consequences for the client, with a corresponding negligence action against the professional adviser.
This article was first published in booklet format at the Australian Family Lawyer's National Convention in October 1998, and is being constantly revised and updated. Television Education Network has produced several videos and audios based on this article. I am grateful to the help I have received from Allan Swan and Wendy Quay of Moores Legal and Michael Flynn, Barrister (Victorian Bar) for their input on tax issues.
WARNING: The following is intended as a guide only to when further expert tax, accounting or financial planning advice is needed. Every case is different, and different fact situations can impact substantially on what otherwise might be a straight forward case. It is trite to say that our tax laws are complex. As indicated, what follows is designed to prompt you to take care in what you are doing when you restructure your client's assets during a divorce.
Peter
Szabo
Principal
Moores Legal
1 July 2009
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REAL ESTATE AND OTHER ASSETS HELD BY INDIVIDUALS
APPORTIONING THE INCOME STREAM
CAPITAL
ASSETS AND TRADING STOCK
INDEMNITIES WITH PARTNERSHIPS
CAPITALISING INSTALMENT PAYMENTS
DIVORCING THE DISCRETIONARY TRUST
INCOME AND ASSETS OF THE TRUST
THE
INCOME STREAM
DEALING
WITH THE ASSETS OF THE TRUST
DISENGAGING CONTROL
LOAN
ACCOUNTS
DIVORCING A SPOUSE FROM THE COMPANY
TAX ISSUES WITH SPOUSAL MAINTENANCE
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DISTRIBUTING THE SPOILS ¾ THE
DIFFERENCE BETWEEN HACKING AND CARVING
The Family Court gives consideration to the parties' respective contributions and to their special needs. An enforced distribution of assets may take place, with the resultant taxation consequences. It is very much up to the parties' legal and financial advisers to ensure that all of the possible consequences are taken into account. This is done either when negotiating a final resolution, or when making submissions to the Family Court regarding what orders it should make.
At this stage a good level of co-operation between the parties and their respective advisers is desirable.
It is not uncommon for a Family Court judge to indicate broadly the likely orders he/she will make after a contested hearing. The parties' legal practitioners are then invited to submit draft minutes of orders designed to give effect to that intention, and for the judge to then settle those orders. There have been instances of the Court requiring one party to co-operate in tax minimisation arrangements recommended by the other party's accountants. It is important to have such information available for consideration by the judge during a hearing. Unnecessary revenue consequences clearly should be avoided.The distribution should also provide for legal and other professional advisers' costs.
Careful attention to the method of dismantling existing structures will be appreciated by clients. The approach by the Family Court is to group all of the parties' respective assets (whether in corporate structures or otherwise) and categorise them as their assets or financial resources. When considering how to distribute and restructure the assets, the tax issues as they apply to the different entities must be carefully considered. The entities may have been established for estate and tax planning reasons, or to achieve limited liability. While the structures may have been effective in minimising tax during the accumulation phase, tax is likely to be payable when dismantling, restructuring or disposing of such assets.
It is impossible to cover all the issues given the enormous complexities involved with taxation. CGT alone is highly complex. Incessant amendments to taxation laws have forced financial advisers to constantly rethink strategies in tax planning, with family breakdown situations being no exception.
A
number of situations are outlined below, with a view to prompting the family
lawyer or financial adviser to seek appropriate help should the warning bells
ring. There is a very real danger that should a party find out that their
expected property settlement is substantially eroded by unforeseen revenue
consequences, they will look to their professional advisers for compensation.
On the other hand, the ability to now split superannuation may offer planning
opportunities which can significantly increase the net asset pool for
distribution between the parties. You need to be aware of these opportunities.
Expert advice should be obtained when you first obtain instructions, not when
the parties are about to sign off on consent orders.
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REAL ESTATE AND OTHER ASSETS HELD BY
INDIVIDUALS
Transfers
of otherwise dutiable assets are almost always exempt from duty where they
occur between spouses as a result of a breakdown of their relationship. This is
either because State/Territory stamp duty legislation allows such transfers
between spouses regardless of the situation (as is the case in
The main residence is exempt from
CGT in most instances. After separation however, a jointly owned residence
becomes the main residence of only one of the parties. That is, CGT can become
applicable to one half of that property. Careful attention to this situation
must now be paid having regard to amendments to tax laws effective 12 December
2006. An obvious solution would be to effect a transfer of the former
matrimonial home to the party in occupation. The issue arises in circumstances
where the exiting spouse purchases another property to live in and (naturally
enough) would want to have that residence treated as their main residence.
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A property purchased prior to 19 September 1985 can be transferred to the other spouse free of any CGT. It retains its exempt status in the hands of the other spouse if the requirements for rollover relief are satisfied.
Inter-spouse transfers of assets subject to CGT (eg investment properties, shares and equities) attract rollover relief if they are consequential to a family breakdown. However to qualify, the transfer must be undertaken pursuant to a Family Court order or under the provisions of a Section 87 agreement approved by the Family Court. These methods both require the scrutiny of the Court in some way and detailed financial disclosure by the parties. Section 86 agreements did not attract CGT rollover relief. While Section 86 agreements have certain benefits in relation to bankruptcy proceedings, they do not have the effect of finalising financial relations between the parties. Accordingly, such agreements were relatively rare and generally frowned upon as a method for resolving family law matters. Further,on 28 December 2000 Section 86 and section 87 agreements were replaced by financial agreements, governed by Section 90B, 90C and 90D. These agreements initially suffered the same weakness as section 86 agreements, in that they were not considered "orders" of the court. Hence, transfers pursuant to these financial agreements did NOT attract rollover relief until 12 December 2006, despite an announcement that the issue would be rectified in the May 2005 Federal Budget.
The rollover provisions have the effect that the transferring spouse does not incur a CGT liability at the time of transfer. Rather, the spouse taking over the asset acquires the same CGT cost base as the other spouse had. CGT is incurred as and when the asset is realised. When calculating the net worth of a settlement to a client, this effect should be kept in mind. There may be some instances where rollover relief is deliberately avoided so that a capital gain is realised. This would be to offset existing losses in appropriate instances. Another example might be where a main residence which is exempt from CGT will later be used for income-earning purposes. In that case, a high cost base may be desirable. The client's advisors should carefully check the particular circumstances of each case to see whether any estate planning opportunities are present. Changes to tax laws effective 12 December 2006, referred to above, now also mean that a jointly owned main residence has potential CGT issues to deal with.
The
impact of amendments to the Tax Act introduced in response to the Ralph Report
(1999) is a perfect example of how quickly changes to tax legislation can
impact on family law settlements. The tax burden arising from the sale of
personally owned assets, including shares and real estate, was effectively
halved from what it was.
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Investment properties are often registered in the name of the higher income-earning spouse, to attract the most effective negative gearing. Remembering that the capital gain on the disposed asset is taxed at the same marginal rate as the owner is taxed, and that the transfer of such an asset to the other spouse is usually not an expensive exercise, there is scope for tax minimisation.
For example, one might transfer an investment property from the higher income-earning spouse to the lower income-earning spouse. That transfer would probably be free of stamp duty and, if properly timed, would attract rollover relief from CGT. (The spouse who acquires the property will, for the purposes of the 50% discount, be treated as having acquired it at the time the transferring spouse acquired the property.) The property could be sold and the proceeds apportioned between the parties, taking into account the tax saved. Alternatively, the transferee could retain it. In that case, an adjustment in favour of the other party would be warranted given the higher net worth of the property to the new owner. If one of the parties has capital losses, the property could be transferred to that party instead, to take advantage of those losses. Again, the tax savings can be apportioned between the parties.
Legal and other costs associated with obtaining title to the asset are relevant to the acquisition costs. Of course, any tax planning must be undertaken with anti-avoidance provisions of tax legislation in mind.
Transfers of motor vehicles between spouses are usually exempt from stamp duty.
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Consider a typical corner store partnership arrangement. There are two primary issues involved in the event of family breakdown. The first relates to the apportionment of the income stream pending a dissolution of the partnership. The second concerns the disposal of capital assets and trading stock.
APPORTIONING THE INCOME STREAM
On a separation, one party invariably takes full control of the partnership resources and income. The ousted (or ''exiting'') partner may call for an accounting of this additional income up until the time the partnership resources are officially allocated by agreement or by Court order.
In reality, the controlling partner continues to control the cash flow. This is then either divided equally or, more commonly, a lesser sum is paid to the exiting party. This usually reflects the fact that the remaining partner bears the brunt of the work and wants to be compensated accordingly. The other party's allocation often takes the form of spousal maintenance and child support. This will be based on that person's actual needs rather than an equal share of the partnership profits. At the end of the financial year, or on dissolution of the partnership, the income is equally divided between the parties for tax purposes. The remaining partner would pay the tax assessed on the allocation to the exiting partner, which usually results in a better net return to both parties.
Thereafter the remaining partner loses the benefit of income splitting. The resulting PAYG and direct tax burden needs to be factored into the settlement equation. In some cases (depending on the terms of the partnership agreement), it may be possible to divide the profits unequally in the year the parties separate in order to take into account changes in the parties' duties. This may allow an advantageous distribution to the spouse with a lower taxable income. Regardless of the outcome, differing tax liabilities between the parties must be taken into account.
Remember
that distributions of partnership income will almost certainly impact on the
eligibility of the exiting spouse to receive a pension. The ultimate
consequences of this must be carefully considered.
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CAPITAL ASSETS AND TRADING STOCK
CGT may apply on dispositions of partnership assets to a spouse. It is important to remember that CGT may apply to a disposal of goodwill even if the goodwill is not recognised in the partnership's balance sheet. However, rollover relief is available in the same manner as is explained above (in relation to real estate), ie there is an exemption for family breakdown. That rollover relief is automatic. In some instances, electing not to take advantage of rollover relief may be appropriate if there are capital losses in existence. This could be achieved by keeping particular asset transfers outside of court orders.
The disposal of trading stock on breakdown of marriage is not in the ordinary course of business and is therefore deemed to be a fully taxable disposal by the partnership for market value. This could be evidenced by the values set out in the parties' respective financial statements filed in court proceedings. Any tax on the resulting profit should be paid by the partners. If rollover relief is available, tax on the profit on that stock should be paid by the transferee spouse. The two options need to be carefully considered in each particular partnership to achieve the best possible net result for the parties.
Depreciable assets are not subject to CGT but any excess of the value of those assets over their written down value may be subject to income tax. If depreciable assets remain with the controlling partner, rollover relief is automatic for transfers on marriage breakdowns. No tax accrues to the exiting partner and the remaining partner retains the rollover benefits. If certain depreciable assets are transferred out of the partnership to one of the spouses, tax consequences may flow and the individual circumstances of any such possibility should be examined. For example, tax consequences could arise from the transfer of plant because of depreciation rules.
In structuring a spouse's exit from the partnership, the remaining spouse may prefer to bypass the operation of the family breakdown CGT rollover provisions and buy the exiting spouse out. For example, if the partnership is profitable and has grown in value, the remaining spouse may wish to obtain a cost base for the partnership interest acquired from the exiting spouse. The remaining spouse will probably want to allocate as high a purchase price as is reasonable, in order to maximise the cost base of the partnership interest.
By contrast, if the rollover provisions are invoked, the remaining spouse will acquire the exiting spouse's cost base which, if the major asset is goodwill, will usually be nil. On a subsequent disposal, the remaining spouse will pay CGT on the entire value of the business even though he/she may have only held the entire business for a short period of time.
If the spouse's exit is structured as a buy-out, the exiting spouse will usually be subject to a CGT liability on the payout, although the capital gain will be subject to the general 50% reduction applicable to disposals after 21 September 1999.
Further,
if the family's business is a "small business entity" (within the
meaning of the Income Tax Assessment Act 1987) then any potential capital gain
may be able to be reduced by acessing the small business CGT concessions
available under Division 152 of that Act. A small business entity is a business
which has net assets of up to $6 million or annual turnover of not more than $2
million. Under these concessions the potential capital gain may be reduced,
deferred or totally exempted from CGT if
it is made directly into a superannuation fund for the benefit of the exiting
spouse. The proceeds would however, remain "locked in" to the
superannuation fund until the relevant member reaches retirement. Nonetheless,
the overall tax benefits would usually justify such a strategy. Another possible outcome is that any capital
gain may be eligible for a reduction of up to 50% under the "active
asset" exemption. The active asset exemption may be applied together with
the general reduction of 50% available to an individual so that the combined
effect is that an exiting spouse may pay tax on only 25% of the capital gain.
There may be no tax payable in that situation if the remaining 25% is
"rolled over" into superannuation.
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Commonly, the exiting partner obtains an indemnity from the remaining partner for all tax liabilities that may arise from his/her involvement in the partnership. This may also extend to limiting the exiting partner's legal liability.
CAPITALISING INSTALMENT PAYMENTS
Situations
frequently arise where one party can only pay the required capital sum by
instalments. The recipient demands interest on that sum. Capitalising that interest
means a tax-effective payment in the hands of the payee. The payer may
negotiate a lower capitalised payment given that benefit. If payments of these
capitalised sums are late, penalty interest (under the Family Court Rules being
13% as at 1 July 2009) could be written into the terms of settlement. This
interest would remain taxable in the hands of the recipient.
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DIVORCING THE DISCRETIONARY TRUST
INCOME AND ASSETS OF THE TRUST
There
are several aspects in relation to discretionary trusts which usually require
attention. These can relate to:
n distributions of trust income and capital;
n
the possible
distribution of trust assets such as real estate, motor vehicles and equities
to one or both of
the spouses; and
n
the removal of the
exiting spouse from points of control of the trust, ie from any involvement as
trustee or in
the trustee company and from appointor or guardianship control.
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As with partnerships, in practice the remaining spouse often controls the cash flow, while the other party receives payments based on considerations such as a reasonable level of spousal maintenance and child support. Distributions of assessable income are usually resolved for tax purposes at the end of each financial year. At that point a decision is made on whether distributions are to continue and who is to pay the tax.
Unlike a partnership, which invariably becomes unworkable with estranged spouses, the trust structure may remain viable despite a family breakdown, and distributions to the exiting spouse may still be possible. However, there are some pitfalls to avoid, eg the exiting spouse may only be a beneficiary by reason of the relationship with the remaining spouse. On divorce, that relationship is severed and the exiting spouse will no longer be a beneficiary of the trust.
A complication to be alert to arises if the trustee has made an election under the Tax Act for the trust to be a “family trust”. If the trust ever needed to take advantage of income losses or bad debt deductions of its own or of a related trust, or received franked dividends, it may have made such an election to use those deductions or franking credits. When this is done, a test individual is nominated. Thereafter the range of tax-effective beneficiaries is narrowed considerably, ie to the immediate family members, close relatives and current spouse of that individual. A divorced spouse was (until the rules were relaxed in 2006) specifically excluded. While that divorced spouse may remain a beneficiary as defined in the trust deed, and therefore eligible to receive distributions of income, penalty tax rates would apply to those distributions if the trust is a family trust, probably making the exercise hardly worthwhile. Accordingly, if distributions to the exiting spouse are desirable, you need to determine whether an election to become a "family trust" has been made and if so, that the exiting spouse remains within the family group for tax purposes.
If the ''prime movers'' of a trust are involved in a family breakdown when a family trust election must be made, care must be taken to nominate the test individual to ensure future tax planning options are not lost. Nominating a prime mover may remove the option of making maintenance payments from the trust to the exiting spouse upon divorce.One solution is to nominate one of the children of the parties as the test individual. This would leave both parents as tax-effective beneficiaries. In summary, the careless nomination of the test individual can have disastrous results as an election is irrevocable once made.
If an election to become a family trust is not made or is not seen to be desirable, the trust must pass more stringent tests to be able to make use of income loss or bad debt deductions. In that case the legislation and possible exemptions for family breakdown need to be carefully examined in each case to ensure that the trust can comply with those more stringent requirements.
Should the ''emotional factor'' come into play, and client co-operation with tax planning issues not be forthcoming, serious financial consequences may result. For example, if the failure to agree on distributions through the trust means the trustee must retain income in a tax year, the trustee will be taxed at the highest marginal rate. The failure to distribute to a spouse during property settlement negotiations may result in a failure to later comply with the pattern of distributions test for the purposes of the trust loss legislation, and the ability to use losses and deductions may be lost.
It
is probable that most discretionary trusts will, at some stage, be forced to
become a family trust for tax purposes. That being the case, financial advisers
need to know who the test individual is and confirm that the election has in
fact been made. These elections can be made simply by the trust's tax agent
making a note on the trust tax return. Liaising with the trust accountant is
therefore essential.
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DEALING WITH THE ASSETS OF THE TRUST
Real estate held by the trustee can, in some instances, be transferred to a spouse, with rollover relief available for CGT purposes. Similarly, stamp duty may be avoided. However, in most States this only applies where the recipient spouse was a beneficiary at the time of the purchase of the property in question, and stamp duty was paid at that time.
Transfers of motor vehicles owned by a trustee will attract stamp duty in most instances.
Other
assets for CGT purposes, such as shares or units in unit trust investments, can
similarly attract rollover relief. Such assets are often also dutiable for
stamp duty purposes and the relevant legislation should be checked for possible
exemptions.
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It
is typical for the exiting spouse to do most, if not all, of the following:
n resign as appointor of the trust;
n transfer any shareholding in the trustee company to the other party or his/her nominee;
n resign as director of the trustee company or as an individual trustee; and
n
(if the remaining
spouse insists) be excluded as a discretionary beneficiary.
The resignation or change of appointor is not considered to be a resettlement of the trust for stamp duty or CGT purposes.
The transfer of a shareholding in the trustee company also does not cause any complication as the company is very often a $2 paid-up company and the trustee is invariably controlled by the appointor. Stamp duty would be on the $1 paid-up share only. The share transfer may, in any event, be exempt as being a transfer between spouses. Care must be taken where the trustee company also owns assets in its own right. In such instances, the most effective strategy may be to remove the company from its trustee role.
The removal of a beneficiary may constitute a resettlement for either stamp duty or CGT purposes. If the trustee can discriminate between the discretionary beneficiaries under the terms of the trust, which is usual, it is often unnecessary to amend the trust deed to exclude the exiting spouse. The trustee, which the remaining spouse controls, can simply cease distributions to the exiting spouse in future. Accordingly, it is often best not to take any active steps to specifically remove the exiting spouse, but care should be taken if the exiting spouse is a taker in default to ensure that he/she does not receive income or capital in default of a decision to distribute income or capital elsewhere.
The
resignation of a director of the trustee company also has no stamp duty or CGT
implications. However, there is one caveat. This relates to the situation where
the trust in question has not elected or does not want to elect to become a
family trust for the purposes of the Tax Act. In this instance, one of the
tests the trust must satisfy in order to use income loss or bad debt deductions
is a continuity in the control of the trust during the relevant period. While a
narrow exemption applies if a change in control is due to a family breakdown
and there is no change in who benefits from the trust, this situation is not straightforward.
Change of control can be occasioned by a change of trustee, a change of
appointor and the resignation of a director of a trustee company. Each
situation must be examined carefully to avoid unwanted consequences.
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Throughout a marriage, a common approach is for distributions to be allocated annually in the accounts of the trust but not actually paid to various beneficiaries, resulting in large loan accounts in favour of those beneficiaries. In the meantime, actual income is loaned to one of the other beneficiaries who then uses the funds to pay for the family's needs. That individual ends up owing the trust a very significant sum. The prudent accountant should annually allocate the expenditure against the relevant beneficiaries' loan accounts. This would also have the effect of reducing the debt owed by the spouse to the trust or vice versa.
If the exiting spouse has a debit loan account with the trust, the best option is to have the loan actually repaid. This could be either by way of a cash payment or by adjusting against the transfer of other assets. If the debt is discharged through an income distribution, tax will be payable by the exiting spouse. Another option would be to forgive the debt, but this may have unwanted tax consequences as well. It could amount to a deemed distribution for the purposes of the trust loss legislation. If the trust has not elected to become a family trust, the trust, as a result of the forgiveness of debt, may not be able to take advantage of tax deductions or capital losses. Alternatively, that forgiveness of debt may force the trust to make an unwanted election to become a family trust for trust loss legislation purposes.
Sometimes the exiting spouse has what appears to be a credit loan account, ie the trust owes money to that individual. Paying the sum out will be tax-free whether it is paid by way of lump sum or by instalments, repayment in cash, adjustments in transfers of property or by forgiving the loan. The repayment of the loan is usually CGT-free. Interest paid on borrowings by the trust to repay credit loan accounts may be tax deductible, provided the credit loan account was not created through a distribution out of an asset distribution reserve. If commercial debt forgiveness provisions apply, there may be an unwanted impact on the trust with the possible reduction of deductions and the CGT cost base of assets. In the typical family trust situation this is not likely to be the case, but it is best to carefully check the circumstances of all loans before deciding which course of action to take.
The ultimate result with most discretionary trusts is for the exiting spouse to resign as director and officeholder, to transfer the shareholding in a trustee company or resign individual or joint trusteeships, and to surrender appointment and guardianship powers. The issue of indemnities must be carefully considered, with the exiting spouse usually receiving a blanket indemnity to cover all possible permutations. Care must be taken to ensure that tax liabilities resulting from trust distributions are covered in case of any tax reassessments arising at a later stage.
Proposals to significantly amend the tax rules
applicable to trusts have been deferred and at the time of writing it is
uncertain whether they will proceed and if so, in what form.
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DIVORCING A SPOUSE FROM THE COMPANY
In
the situation where a family has interests in a company (most commonly a
private company), the following will need to be considered:
n what happens to the income stream from separation until settlement;
n the possible transfer of various assets of the company, in particular real estate and motor vehicles; and
n
the removal of one of
the spouses from the company itself, involving the transfer of any
shareholding, resignation as director, and retirement as employee.
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As with partnerships and trusts, the remaining spouse often controls the cash flow. Appropriate adjustments may need to be made when the matter is resolved, and tax-effective allocations may be made in each relevant financial year. Careful consideration must be given to who will bear the tax burden. As with the partnership scenario, the likelihood is that, upon the parties reaching a settlement, distributions of income or profit to the exiting spouse are unlikely to continue, as that spouse will no longer be involved with the entity.
The
remaining spouse will need to consider carefully any arrangements entered into
to ensure that unexpected tax liabilities are avoided. If the exiting spouse is
an employee of the company, the likelihood is that the employment will be
terminated and the income stream will cease. The remaining spouse will retain
the company and its underlying assets, but may have lost the ability to
minimise income tax consequences.
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TRANSFERS OF ASSETS FROM THE COMPANY
A conveyance of real property by a
company may, in some circumstances be exempt from stamp duty. However, the
relevant state legislation should be checked.
The main residence exemption for CGT does not apply to company-owned premises. Rollover relief is available if the transfer is by court order or a section 87 Agreement. In that case, there is no election and rollover relief applies automatically. Note however, that as companies are taxed on distributions of profit, the otherwise exempt captial growth of assets will be effectively taxed at the company tax rate, currently 30%. This issue is far more difficult to avoid. See discussion below.
There may be times when it would be better to avoid rollover relief, eg where the company has a capital loss made which would offset a capital gain. In that case, some transactions should be undertaken before the finally documented property settlement between the parties takes place, thus side-stepping the compulsory rollover effect. These transactions should take place before the final court documentation is executed, otherwise there can be severe problems with enforcement should either party go back on the deal after the orders or agreement have been put in place.
The transfer of a motor vehicle from a company to a spouse will attract stamp duty and might also subject the company to an FBT liability. A further risk of transferring a motor vehicle to a spouse is that the transfer might be deemed to be a dividend equal to the value of the motor vehicle, which would be fully taxable to the spouse receiving it. In the latter case FBT would not apply. There is also the possibility of of GST applying.
Court orders requiring the company to make cash payment to a spouse may avoid Deemed Dividend issue
As a result of the extended powers the Court now has over third parties (operative from 18 December 2005) certain tax planning options may be possible. Where funds are in held in the name of the company, a payment out to one or both of the parties could well be treated as a deemed dividend. However, recent private tax rulings suggest that if the company was made a party to those orders, and was instead ordered to make the payments, this might avoid the problem. The payment becomes an obligation of the company. The exemption appears to be limited to cash payments and not to transfers of assets.
A common transaction in family breakdown situations is for an exiting spouse to retain a company owned motor vehicle. Care must be taken to avoid having this transaction being deemed a dividend. One solution is for the exiting spouse to purchase the vehicle at market value, and for the other spouse to make an appropriate additional payment to cover that transaction, provided there are sufficient resources outside of the company. Otherwise, the company should be made a party to the orders and ordered to make the appropriate payment to the exiting spouse. Stamp duty would be payable. So would CGT, although with motor vehicles this is unlikely.
The same concept would apply for real estate.
Stamp duty and CGT are more likely to be a problem, as could GST for commercial
properties. It is a matter of ascertaining what most cost effective solution
is.
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Stamp
duty exemptions due to family breakdown are likely to apply in most States.
in the other States and
Territories duty is assessed on the higher of the market value of the shares or
the consideration paid for the transfer of the shares.
Inter-spouse transfers will constitute a disposal for CGT purposes. Where there is a rollover, a pre-CGT asset retains that status. With a post-CGT asset, the transferee retains the transferor's cost base and the transferor does not make a capital gain. If there is no rollover relief, a pre-CGT asset becomes subject to CGT and the deemed cost base is current market value at the time of acquisition. Valuations obtained for Family Court proceedings would be evidence of that market value.
There
is a further possible CGT issue if the company owns pre-CGT assets. In this
case, a change of 50% or more in the underlying ownership of the company
effectively ''freshens up'' pre-CGT assets to make them subject to CGT for
remaining shareholders. An exemption applies for family breakdown situations,
although such situations can cause potential problems for companies in which
shareholders are not restricted to solely the spouses.
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If
a company has tax losses, particular care must be taken so as not to
inadvertently lose the ability to make use of those losses or deductions. For
tax purposes, to make use of carried forward losses, the company has to satisfy
one of two tests. One is the ''continuity of ownership'' test; if that is failed,
the other is the ''continuity of business'' test. The latter test is difficult
to satisfy, hence qualification under the first head is desirable. To achieve
this, there must be a continuity of ownership of shares carrying more than 50%
of all voting, dividend and capital entitlement. Practically speaking, this
means that if spouses are each 50% shareholders, the exiting spouse must not
transfer all of his/her shares until the use of losses is no longer required. A
restructuring of the shareholding may be necessary to give effect to this
result. Where the company is owned by a discretionary trust, the situation may
force the trust to elect to become a "family trust" election (as
discussed above) in order for the company to use that loss. This of course significantly
limits the class of tax-effective beneficiaries of the shareholder trust.
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The tax issues with respect to loan account entitlements are potentially complex. Issues which require attention include the commercial debt forgiveness provisions, the potential deeming of dividends and potential fringe benefits tax (FBT) implications.
Loans to ''associated persons'' of the company may become subject to the deemed dividend rules. "Associated persons" includes shareholders, their spouses, and related entities. Whether the loans were made or their terms varied before or after 4 December 1997 will also need to be determined. On that date, legislation came into effect that automatically deems loans from a company to a shareholder and related associates to be a dividend, subject to limited exceptions. If proper account-keeping records are not available, the deeming provisions may come into play, depending on how you attempt to disengage the parties.
One obvious (and the safest) solution to the problem is for the exiting spouse to repay the loan to the company. Sometimes this is just not possible.
A temptation is for the loan simply to be forgiven. However, forgiving the debt may result in the deeming of an unfranked dividend in the hands of the exiting spouse. Correspondingly, if that loan was post 4 December 1997, the company would lose any franking credits it may have had. One way around this problem is to repay the loan from the proceeds of a franked dividend paid to the exiting spouse. While this may use some of the company's available franking credits, in the overall scheme of things it may have a better net result, provided both parties consider the tax ramifications.
Fringe Benefits Tax issues may also arise if the spouse is an employee. If interest has not been charged, this potential ramification is more likely. The commercial debt forgiveness rules may also apply if the exiting spouse used the loan moneys for income-producing purposes to deny the benefit of available tax deductions or to reduce the cost base of assets purchased from those funds in the hands of the exiting spouse. Clearly, the exiting spouse will want indemnities to cover any possible tax liability that may arise.
Another way of dealing with the loan would be as part of the exiting spouse's termination of employment from the company. The issue would have to be addressed in any event to ensure that the company and the remaining spouse were released from any obligations to the exiting spouse under employment laws. Each particular case needs to be checked carefully for potential benefits or problems.
The
exiting spouse needs to ensure that appropriate indemnities are obtained from
the remaining spouse and also from the company in relation to any liabilities
which may arise from dealing with the loan. Where the exiting spouse is a
shareholder, or an associate of a shareholder in a private company as defined
for tax purposes, the very existence of the loan, the forgiveness by the
company of a debit loan or the conversion of the loan to a payment other than a
franked dividend could bring about the above results.
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Credit
loan accounts involve loans to companies from a spouse. The best option would
be for the loan to be repaid to the exiting spouse. Generally this would be
CGT-free in the hands of the recipient. Interest on borrowings by the company
may be tax deductible depending on the circumstances of the loan. The company
records should ensure that the transaction is properly documented as a
repayment of the existing loan. Failure to do so could result in the repayment
being deemed an unfranked dividend, which results in higher tax for the
recipient and the loss of franking credits to the company.It should be noted
that after 1 July 2004 interest free and "at call" loans to a company
may be non-deductible.
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On 18 December 2004 the Family Courts powers over third parties were dramatically extended. Whilst the constitutional validity of these powers is questionable, they are at this point valid. Broadly, these powers now mean that some of the following situations are now possible. A bank might be ordered by the Court to release a spouse from a Mortgage, leaving the other solely responsible for the debt. Parents could be ordered to sell a farm property to satisfy a claim being made against one of their children by an estranged spouse. A Company likewise could be ordered to transfer a motor vehicle to a spouse, or to make a payment to that spouse. In the case of banks, no adjustment is to be made unless there is a high probability that the loan will be repaid.
The Court’s preferred approach is not to interfere with third party rights where there are enough assets in the control of one or both to the parties to achieve a fair result. However, situations arise where all assets are out of the direct control of the parties. A relatively common example is the farm property owned by the parents referred to above. The married couple have contributed to the farming venture, often for many years in the expectation of inheriting the land. On separation, the son or daughter in law finds themselves in a very difficult position. The remaining spouse of course is likely to one day gain their inheritance, its value increased by the efforts of their former spouse. Now the excluded spouse may have a more powerful remedy to bring the other party to the bargaining table.
Adverse
taxation consequences may sometimes flow on to others involved in the business
structure, even if those adjustments are only as between the spouses.
An obvious example is where a
settlement involves a change in the shareholding of a company which holds
assets. This could cause pre-CGT assets held by the company to be freshened up
and become subject to CGT, or the benefit of losses or deductions being
forfeited. Similarly, the way in which loan accounts are dealt with may attract
deemed dividend issues, FBT liabilities, loss of cost base problems and the
inability to use deductions and other losses.
The
financial consequences of Family Court adjustments to other shareholders may be
significant indeed. It may be worthwhile for business partners to keep a
careful eye on those possible consequences and take remedial action where
appropriate.
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FUTURE TAX ASSESSMENTS TO THE INDIVIDUAL
As previously indicated, dealing
with the income streams of partnerships, trusts and companies from separation
until final disengagement requires adjustments for tax liabilities. This may
result in taxation assessments being made in later years and both parties must
be clear on who is to pay them. Financial advisers must ensure that indemnities
are put in place where appropriate and that they are backed by appropriate
security. An unsecured indemnity for the payment of tax is of course useless
where the other spouse has gone bankrupt or absconded with all the assets. For
that reason also, debit loan accounts must be properly dealt with and releases
obtained from the corporate entity.
An often overlooked situation is the issue of tax refunds. If the
exiting spouse has a reducing income stream, PAYG tax payments will result in
significant tax refunds arising the following year. Logically, the spouse who
pays the tax in the first place should have the benefit of that refund in later
years.
Depending on what restructuring strategies are adopted, additional
accounting expenses can be incurred. The preparation of additional books of
account other than at the end of the financial year might be required. For
example, the resignation of a director in a non-fixed trust situation where a
family trust election is not possible or wanted could trigger this requirement,
while the change of directorship may trigger a different treatment of the trust
for tax purposes.
In many instances, the actual date of resignation of a director makes no
difference to the exiting spouse and the simple step of co-ordinating that
resignation with the end of the financial year can avoid unnecessary paperwork
and expense, or the necessity to rely on the Commissioner's discretion. Of
course there may be good reason for the exiting spouse to immediately resign as
a director of a company, given the potential for personal liability for debts
where companies are trading when insolvent. For companies that are employers,
directors are made personally liable for the non-payment of PAYG deductions to
the ATO, even if they had no knowledge or control over the non-payment. The
resignation should therefore take place as soon as possible to avoid these
situations.
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GST – Goods and Services
Tax
There is no "rollover" relief on a breakdown of marriage with
GST as there is with CGT. The ATO issued rulings in early 2003 confirming the
position.
Transfers of real estate and other assets between husband and wife
personally will generally not attract GST. This is primarily due to the fact
that they are not considered to be “supplies” made “in the
course or furtherance” of an “enterprise” for the purposes of
the legislation. That said, investment property transfers may in some instances
incur GST, such as where the holding of that real estate is seen to be "an
enterprise".
Where there are entities other than individuals involved (and for tax
purposes this includes partnerships), and where there are business assets, the
situation requires very careful analysis. Each transaction within the
settlement reached must be carefully considered. In a simple case where one
party retains the entity and the other keeps outside assets, GST is probably
not payable. This will depend on how the entity is structured and how the
disengagement of the exiting spouse is structured. Where, for example, the wife
receives the partnership/entity motor vehicle, GST will be payable on that
transaction by the partnership/entity. With the common husband/wife
partnership, by definition there is a dissolution of partnership when one party
disengages. In that case the partnership may incur a GST liability by
transferring assets to the remaining spouse. The parties are jointly liable for
this payment.
It
may be possible to minimise the impact of GST on a transfer of business assets
from one entity to another or to an individual by having the transaction
undertaken as a sale of a “going concern”. Otherwise, the exiting
spouse (the "vendor") may incur a GST liability. In normal
circumstances, a spouse leaving the business would expect the remaining spouse
to accept full responsibility for any tax or other revenue costs associated
with that transaction. Husband/wife partnerships can pose particular problems.
Whilst the remaining spouse will be considered an "entity" carrying
on the business, care must be taken to ensure that further unwanted revenue
triggers (such as CGT or stamp duty) are not activated. Where third parties are
involved in an entity, the situation is potentially more complex, remembering
that the entity is often liable for the GST imposed.
Accordingly, the general approach in family law matters would be for the
exiting spouse to receive an indemnity from the remaining spouse should any GST
be payable as a result of any transactions as between them and the entities
they are involved in. The spouse giving that indemnity should know the value of
it by being made fully aware of the GST consequences of the family law
settlement. Care should also be taken to ensure that any credits for GST revert
to the intended party. The giving of the indemnity to the exiting spouse itself
is not likely to be subject to GST.
The concept underlying the Tax Office's approach to GST is that if parties
have obtained the tax benefits of an entity holding their assets (for example
by being able to claim GST imput tax credits), taking them out of that entity
will incur GST despite this being solely the result of a marital breakdown.
This may cause hardship in many cases, but that is the reality of the situation
at present. Clearly, specialist accounting advice is needed before formalising
arrangements in such cases.
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TAX ISSUES WITH SPOUSAL MAINTENANCE
In
Partnerships: The distribution of income in lieu of maintenance can
only be up to and including the time of dissolution of that partnership.
Income, of course, is taxable in the hands of the recipient whereas maintenance
is not taxable. Following dissolution of the partnership, there is no right
remaining for the exiting spouse to receive partnership income. This does not
include capitalised payments or instalment payments. However, these do not give
the payer tax deductions nor are they taxable in the hands of the recipient.
Trust distributions: The ability to distribute to the exiting spouse
remains, but the tax effectiveness can be severely challenged as a result of
the election to become a family trust. If the election has taken place, the
test individual must not have been the remaining spouse, otherwise this avenue
is lost. If no election has been made or if the exiting spouse remains within
the family group, distributions can continue as before.
Companies: If the parties
so wish, it may be possible, subject to the value shifting rules, to
restructure the company to allow the exiting spouse to have dividend access
shares with no rights to vote or attend meetings, and so on. Otherwise,
payments will cease when the exiting spouse stops working for the company and
removes him/herself as shareholder and director.
Spousal maintenance and
termination packages for spouses:
Where the parties are employed in a family business and one party retires, it
may be possible to structure a ''retirement package'' tax effectively. The
spouse, however, must have been performing real and substantial duties as an
employee or company director. Payment likewise must be made in good faith and
in consideration of past services, and must be a reasonable sum having regard
to those considerations. Such a payment would be tax deductible to the employer
but will nonetheless be treated as an eligible termination payment to the
exiting spouse, who will be taxed on that payment on a concessional basis. In
considering the above, careful attention needs to be given to the impact such
planning will have on possible pension entitlements.
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Lump sum payments and use of assets
Spousal maintenance can be satisfied by way of a lump sum payment or the
provision of a right to use assets. Lump sum payments are capital. The amount
in question may affect the assets test for pension purposes. There is no tax
benefit for the recipient in this case. In some cases it may be possible for
one spouse to provide the other with the use of property or a motor vehicle.
However, that invariably means that any tax deductions for maintaining the
premises or vehicle will not be claimable by the spouse providing the benefit.
In
considering options for the tax-effective payment of spousal maintenance, the
full financial circumstances of both parties must be carefully considered. In
structuring any settlement between the parties, the terms of settlement must
clearly spell out who is to bear the tax burden.
TAX CONSIDERATIONS FOR CHILD SUPPORT
Given that child support is paid out of after-tax income, payments in
the hands of the recipient are tax-exempt and are not tax deductible to the
payer.
It is clear that manipulation of the administrative assessment is
possible. For example, upon separation a payer may persuade his/her employer to
restructure his/her salary package. Obviously, FBT would apply which would be
payable by the employer. However, the net amount of the package payable to the
employee could be less than before, so that the employer would benefit from
this arrangement. The employee likewise would benefit because of the reduced
child support obligation which results from the narrow interpretation of
taxable income for child support purposes.
However, as from 1 April 1999, the Government introduced changes in
relation to reportable fringe benefits. The purpose of the changes was to enhance
the fairness of the taxation and social security systems. The effect of this is
that the Child Support Agency will be able to
''add back'' those benefits when making an initial assessment.
Nevertheless, it is likely that salary sacrificing would still result in a
lower assessment than would otherwise be the case.
Even though the payee can seek an administrative review or, if
appropriate, a departure order from the Court to rectify the situation, the
enforcement of child support reverts to the Child Support Agency. The Agency's
ability to enforce the payments is limited to a percentage only of the taxable
income, not counting the protected amount, and again fringe benefits are not
''added back''. Invariably this means that although a higher child support
amount is payable, the Child Support Agency cannot enforce the full payment
unless a tax refund is due or there are cash or other assets available for
sale. In these situations, parties commonly negotiate child support agreements
for fixed amounts per annum to be increased by an inflation factor, as well as
the provision of other expenses such as medical cover and private school fees.
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Child support trusts
Normally, unearned income of minors attracts a penal tax rate. The
non-taxable threshold is only $416 although in certain circumstances it is
possible to lift this limit to around $1,800.00. It is therefore not usually
tax effective to distribute assessable income to minors from trusts or other
structures. The major exemption is where such income will be treated as
''excepted trust income'' if it is derived from property transferred to a
trustee as a result of family breakdown.
Child support trusts were relatively popular during the 1980s. A variety
of amendments to the Tax Act were implemented in 1994 whereby on the one hand
the number of people who may potentially benefit from the use of a child
maintenance trust was increased and, on the other hand, the requirements for a
transfer of property to that trust and the ability to invest such property were
tightened up considerably.
Nowadays children of a broken marriage, of a broken de facto marriage,
and even those who are the result of a ''one night stand'' come under the
definition of a ''family breakdown''.
The qualification for the establishment of a child support trust is a
legal liability to pay child support. This is evidenced by the existence of an
assessment under the Child Support
(Assessment) Act 1989.
A
simple example of a maintenance trust would be the transferring of, for
example, $400,000 cash to a trust. The income generated could be distributed to
infant beneficiaries and marginal tax rates would apply, provided the income is
derived at arm's length rates. The capital must pass to the children when the
trust ends. Many people do not have such cash available to give to their
children. Hence, other alternatives may need to be investigated carefully. Some
examples could be the transfer of units in a unit trust which conducts a
business, the transfer of units in a service provider trust or the transfer of
an investment property. Such transfers do not attract stamp duty exemptions or
CGT rollover relief and this must be taken into account in determining whether
a child support trust is viable.
For family law purposes, the possibility of a child support trust is
well worth considering, as the gaining of a tax advantage invariably means the
payer has more disposable income to pay maintenance for the benefit of the
children.
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ADVANCE
PLANNING
Cohabitation, prenuptial and financial agreements
Because of the emotional issues
involved, few couples are willing to consider problems that may arise on a
separation when they enter into a relationship, even though it is clearly
sensible to do so given the incidence of divorce in this country. Cohabitation
or pre-nuptial agreements are becoming more common. If the parties do not
marry, State Legislation applies to the relationship. Most States do give
considerable recognition to them.
As of 28 December 2000, legislation introduced into the Family Law Act
the concept of legally binding Financial Agreements. Couples contemplating
marriage can now make enforceable contracts, provided they satisfy the
stringent requirements set out in the legislation. Independent legal advice is
mandatory. Lawyers acting for the parties must certify that certain
advice was given. Prior to this development, the Family Court would only
enforce the terms of a cohabitation agreement if the terms were fair,
independent legal advice had been given, and the parties had abided by the
terms of the agreement. Even then, the Court in its discretion could make other
orders, thereby effectively circumventing the effects of the agreement. A
financial agreement that satisfies the provisions of the Act is binding on the
parties, thus reversing the previous approach.
Financial agreements can also finalise the right of a spouse to future
spousal maintenance support, unless that party is entitled to a pension at the
time the agreement comes into effect. This issue was previously only
capable of being addressed in what were known as Section 87 Agreements. Those
agreements were subject to court scrutiny and approval (not easily obtained),
without which they were void. They were replaced by financial agreements in
2000. The ability to lock out this possible future right is a valuable prize.
An agreement enables both parties to address problems that arise if the
marriage breaks down, without the emotional factors coming into play. Assets
owned prior to the marriage can be quarantined, as can inheritances or advances
received from family during the marriage. Unfettered, both of these issues
cause enormous heartache for the parties and their families. Whilst the Court
will inevitably provide a fair result in most cases, it is far better for the
parties to determine this in advance, if at all possible. This provides the
opportunity to undertake succession planning with more certainty. With
"Greying Australia" this issue is becoming far more important for
clients. A financial agreement could include deadlock-breaking devices for a
partnership, such as the appointment of an independent manager on a separation
or for the automatic changing of company shareholders' rights on a divorce.
Another use could be to specifically categorise an advance from a parent as a
loan that must be repaid in the event of a separation.
Couples who entered into a prenuptual agreement prior to 28 December
2000 must enter into a fresh agreement which complies with the new requirements
to make them binding. The legislation also allows married couples to enter into
financial agreements, to define their financial rights and responsibilities in
the event of a breakdown of the relationship. Likewise, financial agreements
can also be used by separating and divorcing parties to document the terms of
settlement reached between them.
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Tax planning structures require flexibility
Hopefully, careful consideration of the above will alert the financial
adviser or estate planner to some preventative measures. Attention might be
given to problems associated with changing the ''underlying majority interest''
referred to above. Hence the prime mover should own the majority of the shares
so that, if a breakdown does occur, the transfer of a minority interest does
not attract CGT liabilities or prevent the use of carried forward losses or
deductions. The nomination of a trust as a family trust can also have
unfortunate ramifications. The consequences of a poor choice of test individual
could mean that spousal maintenance payments are limited, passing control of
that trust to the spouse is not possible as part of a divorce settlement, and
the value of the trust as a tax planning vehicle is diminished. Luckily
announcements in the July 2006 budget meant that the possible negative impact
has been watered down significantly.
One-director companies may be an option. However, more than two shares should
be issued to allow for a restructuring later on if required (preferably at
least 100 shares should be issued). Partnership agreements can be written to
allow an uneven distribution of income in certain circumstances. Self managed
superannuation funds have more flexibility for restructuring, should the
parties separate, as compared with apportioning other types of funds.
Wills also need to be drafted to take into account blended family
situations and the possibility of bequests being made at an inappropriate time,
such as when the recipient is bankrupt or is in the middle of divorce
proceedings. Some flexibility may be useful, with testamentary trusts providing
that benefit.
Throughout the life of an entity, accountants need to ensure that all
loan account entitlements are properly documented and recorded, whether to or
from entities, or from parents to their married children. Proper housekeeping
is essential.
While a divorce forces estate planning on parties at an inappropriate
time, lateral thinking by professional advisers can minimise the negative
consequences. Your clients will appreciate the effort put into such strategic
planning.
2009