There are plenty of tax issues and traps in assisting clients with divorce settlements.
Have the assets been tax-effected to give a ‘real’ picture of the net wealth of the couple? How will Division 7A apply where there are assets in companies?
One issue that is not always thought about is whether there are any tax consequences of a beneficiary of a trust disclaiming or revoking their interest in a discretionary trust. There are a significant number of CGT events that cover a large number of possible situations, including events like C2 which applies where a CGT asset ceases to exist, and the various ‘E’ events, which can apply where a beneficiary’s interest in a trust ends.
An idea of these can best be shown by way of an example.
Alex and Penny are getting divorced. They have a home worth $1m in joint names and a discretionary trust which runs their business which they have built up to be worth $5m. They have lived on the trust distributions rather than take salaries from the business (and have not taken their accountant’s advice to plan for retirement by contributing into super). They agree that Penny will get the house and $1.5m cash and will leave the business and disclaim any interest she has in the trust, whilst Alex will move to sole control of the trust.
As the $1.5m is coming from the trust their accountant has identified two ways of accounting for the transaction.
Firstly the money can be advanced to Alex as a loan and he can pay out Penny. Secondly the business could be revalued and the divorce settlement could require the trust to pay out the $1.5m as a capital distribution to Penny at the same time that she disclaims her interest in the trust.
In the first example Alex will have a tax bill over time as the profit distributions to him are applied to reduce his loan. This is likely to be higher than the tax that he and Penny used to pay when they shared the profits. The actual payment of funds by Alex to Penny will not give rise to any tax bill even though technically Event A1 applies – this is because his cost base will be the nominal value of the cash, and also because he is required to make the payment by the Court Order and so Division 126-A protects him from any gain.
In this example, there is no transaction between Penny and the trust that can be characterised as her being paid to give up her trust interest and so there is little likelihood that the ATO would seek to argue that there is any taxable gain arising here.
In the second example, the trust has created a subtrust by making a capital distribution. This subtrust has a single beneficiary who is entitled to an amount from it. The paying out of such an entitlement is an E8 Event – and whilst no capital gain or loss should arise it may be that one does if assets are distributed in specie to pay out the entitlement. Further the trust’s accounts now have a reduced asset revaluation reserve such that when the business is eventually sold there will be a mismatch between the trust law capital gain and the taxable capital gain – this may give rise to complications for Alex in the future such as managing this difference whilst trying to access the small business CGT concessions.
The income each year from the trust will still flow to Alex, so no income tax is saved by choosing the second outcome.
We note that there are good technical arguments that being a beneficiary of a trust does not give rise to an asset capable of disposition, and that the market value of a right merely to be considered by the trustee in their absolute discretion as to whom to distribute to is something with very little, if any, market value. The aim is to make sure that any risk is not increased by the way the divorce settlement is structured.