Ensure your ex-spouse doesn’t leave you with an unexpected tax bill

When a marriage or de facto relationship breaks down, the division of assets can be complex, particularly where those assets are held within family business groups involving companies and trusts.

While family law outcomes are often focused on achieving equitable division, the tax consequences of how assets are transferred can materially affect the real value received by each party.

Understanding the interaction between the Family Law Act 1975 and Australia’s capital gains tax (CGT) regime is critical to avoiding unintended tax costs.

Asset transfers under the Family Law Act

Australian tax law provides specific CGT rollovers for asset transfers that occur because of a court order, binding financial agreement, or similar instrument made under the Family Law Act 1975.

Where these provisions apply:

• The entity transferring the asset (whether an individual, company or trustee) disregards any capital gain arising from the transfer.
• The receiving spouse generally inherits the transferor’s existing CGT cost base, or any pre-CGT status.

This rollover relief can apply not only to assets owned personally by spouses, but also to assets held by family companies and trusts, provided the transfer is compelled or sanctioned by a qualifying family law instrument.

It is critical to note that while rollover relief will stop an immediate CGT tax impost, as the receiving spouse inherits the original cost base, there will often be an inherent tax liability on eventual disposal.

Transfers of assets that would otherwise be subject to State transfer duty are also generally exempt if transferred pursuant to a Family Law Act agreement.

Transfers outside the Family Law Act: A critical distinction

Where assets are transferred by agreement only, without being sanctioned under the Family Law Act, the CGT rollover provisions do not apply. In these circumstances, the tax outcome differs significantly depending on whether the asset is held by a company or a discretionary trust.

This distinction is often overlooked but can result in materially different after-tax outcomes.

Example: Asset transfer by a family company

Consider a property owned by a family company:

• Market value: $1,000,000
• Cost base: $500,000

If the property is transferred to a spouse under a Family Court order, Subdivision 126-A of the Income Tax Assessment Act 1997 applies:

• The company disregards the $500,000 capital gain.
• The receiving spouse acquires the property with a $500,000 cost base.

If the transfer is outside of a Family Court order, there would be no rollover for the company, which would have to pay tax on the capital gain.

In both cases, separate tax issues can still arise. The ATO’s view is that:

• To the extent a transfer of money or property is made to a spouse who is also a shareholder, it may be treated as an ordinary frankable dividend, limited to the company’s retained profits (regardless of any CGT rollover) and the company’s franking credits.  In the above example, the spouse would be taxed on a $1 million dividend.
• Where retained profits are insufficient, or where the spouse is not a shareholder but merely an associate, the transfer (or excess) may be treated as a Division 7A deemed dividend (regardless of any CGT rollover) which is unfranked.

This dividend layer can significantly erode the tax effectiveness of company-held asset transfers.

Example: Asset transfer by a family trust

Now consider an equivalent property held by a discretionary trust with the same value and cost base.

Where the transfer occurs under the Family Law Act, the trustee can disregard the capital gain, and the beneficiary spouse receives the asset with the trustee’s original cost base. This effectively defers the tax until the spouse sells the asset.

Where the transfer is not made under a Family Law instrument, CGT Event E5 under the Income Tax Assessment Act 1997 applies. The trustee is taken to make a capital gain based on the difference between the market value of the asset and its cost base. This capital gain may be distributed to the recipient beneficiary. The capital gain could attract the general 50% CGT discount, so the overall tax should be capped at 23.5%

Why trusts often deliver better outcomes

Unlike company distributions, trust distributions do not carry an additional actual or deemed dividend layer. As a result, dollar for dollar, the transfer of CGT assets from a discretionary trust can be substantially more tax-efficient than equivalent transfers from a private company.

This difference can be decisive when comparing “equal” asset divisions on paper that are, in reality, not equal after tax.

Other important considerations

Several additional tax issues frequently arise in relationship breakdowns:

• Cash distributions made under the Family Law Act 1975 generally do not cause an additional tax liability for the company or trust which distributes it. However, the spouse receiving a distribution from a company may need to pay tax on it (eg as a dividend / deemed dividend).
• If transferring business assets, there is a corresponding exemption for certain depreciating assets (such as plant and equipment) where CGT relief would otherwise apply.
• There is no exemption for Trading stock, so that transfers of trading stock may still trigger assessable income, regardless of whether the transfer is made under family law provisions.

Key takeaway and how Exant Advisory can help

In family group restructures following a relationship breakdown, achieving a fair outcome requires more than simply comparing market values of the assets in the matrimonial asset pool. The type of entity holding the asset, the tax characteristics of the asset, and whether the transfer is mandated under the Family Law Act can all dramatically alter the after-tax result.

The net after-tax position of each spouse should be considered when dividing the asset pool. Early tax advice, coordinated with family law strategy, is essential to ensure that asset divisions are genuinely equitable, rather than equal in name only.

If you require assistance with a family group restructure following a relationship breakdown, contact your usual Exant Advisor or alternatively our tax specialists, Jamie Towers and Dean Rallison via the form below or on 07 3218 3900.

Author:  Dean Rallison