Splitting business assets on divorce

We had the pleasure of hosting the above workshop at the recent Family Practice Conference, along with our colleagues Daniel Sladen and Kayleigh Everson from K3 Tax Advisory Limited. Attendance numbers were high and we had good interaction with practitioners involved in financial remedy cases. Our session followed a case study, designed to highlight many of the common issues that arise when valuing both new and established business assets with trading income and property. Tax is crucial from an asset-splitting perspective and this formed a large part of the discussion.

The hot topic of the moment for tax on divorce is, of course, the upcoming April 2023 amendments (assuming no last-minute U-turns from the government). We have also seen a number of recent cases where one party suspects the other to have funded their lifestyle out of the company. For valuation and tax purposes, neither of the above are straightforward and these were two of the key themes we investigated in our workshop.

April 2023: the end of tax on divorce?

Currently, disposals on divorce are eligible for nil gain nil loss in the tax year of separation. Proposed changes look to extend tax relief to three years from the end of the tax year of separation (or indefinitely where assets are transferred under a court order). Whilst these changes have not yet been given Royal Assent there is no indication that this will not happen.

The devil is in the detail

In order to benefit from the nil gain nil loss provisions, the transfer of assets must be between spouses. This condition may not be of consequence in cases where the parties have significant liquid assets or other assets which can be transferred to balance a settlement between them. However, in cases with few liquid assets and a high-value business asset it may be necessary to extract and distribute cash or other assets from the company. Transactions between a party and the company do not qualify for nil gain nil loss and therefore will still be liable for tax.

The quantum of tax on extraction of assets is, of course, subject to:

1. the method of extraction (be that by dividend, share buy-back, incorporation of a holding company to acquire shares or otherwise); and
2. the reliefs available to the parties, such as Business Asset Disposal Relief (BADR), or whether capital/income treatment applies.

We discussed with our delegates the impact of different structures from a tax perspective – the pros and cons of which are ultimately case specific. However, due to the lower tax rates it is typically more tax efficient to undertake a route resulting in CGT rather than income tax where possible.

Even in relatively straightforward asset transfers, family law practitioners will now need to carefully consider the timing of any transfer, financial order, or court order in light of the potential differences in tax due and in order to benefit from new reliefs.

Actions speak louder than words

One of the takeaways from our workshop was how the actions taken by the parties can determine how much tax will be paid. For example, where both parties are directors and shareholders of a business, one party will typically want to step away and may seek to resign as a director (there may be pressure for this to happen during the divorce process). It can be costly though – BADR, which caps the CGT rate to 10% on the first £1m of gains, is only eligible to individuals who (amongst other criteria) are an officer or employee at the date of disposal and who have been in post for at least two years. Resigning, even if this is reversed shortly afterwards, is ill advised.

Personal costs: friend or foe?

In our case study we considered a husband who had funded personal costs through his business and questioned whether this had an impact on company valuation or tax – an issue that many of our delegates could recall from their own cases.

Big spenders

Many spouses with no access to company records, who see their partner spending freely on holidays, luxury goods and the like, expect that either:

• the company can afford a large income (such that valuation will be high); or
• fraudulent activity is at play (leading to concern that profits and therefore valuation will be understated).

We noted that it is common for owner-managers to pay for personal costs using company funds. If accounted for correctly, through a director’s loan account (recorded as amounts due back to the company), this will have no impact on profits or maintainable earnings. If not repaid, the company and director become liable for tax.

The other side of the coin

If payments are instead accounted for through the profit and loss account as if they are company costs, this can have significant implications on the company’s value and constitutes tax fraud (for which tax, interest and penalties will be levied on the company and the director in question). For valuation purposes it would be necessary to increase profits in this situation to remove personal costs (increasing the valuation) and account for a company tax liability as a reduction in the valuation.

In our experience, especially where undertaken over many years, the tax, interest and penalties relating to fraudulent activities can be material to and even in excess of the company valuation. It is easy to focus on the end goal here without considering the commercial reality that many purchasers would not be prepared to pay more for a business engaged in fraudulent activity – what else might be under the bonnet when they take a closer look?

Food for thought

We hope that our workshop provided an interactive opportunity to revisit some of the more complex aspects of business valuation and tax and thank all of our delegates for their contributions and observations.