Nobody enjoys thinking about taxes but an important component of family law property settlements that often goes unmentioned is the identification and evaluation of any taxation liabilities. An unexpected tax liability can significantly impact the value of the asset pool and therefore must be accounted for.
The first step in a property settlement is the identification of the party’s asset pool, being the assets, liabilities, and superannuation. These liabilities can include debts such as mortgages and extends to any taxation liabilities. Taxation in property settlements can be a complex issue, especially when components such as Capital Gains Tax (‘CGT’) and Division 7A of the Income Tax Assessment Act 1936 (Cth) are relevant.
Capital Gains Tax
CGT is a tax on the profit realised on the sale or transfer of assets such as stocks, bonds, investment properties, and other property. A capital gain occurs when the sale price of a capital asset is greater than the asset’s cost. Certain deductions may be made when calculating capital gain such as the cost of sale. A taxpayer must record their capital gain on their assessable income for the applicable financial year. The capital gain may be subject to CGT.
In a family law matter the adjustment of property between parties may cause a CGT liability to arise from the sale, transfer, or disposal of an asset. As a result, CGT can affect the fairness of a property settlement and should always be considered in a settlement.
There are two important exceptions to CGT which can apply in a property settlement.
Main Residence Exemption
The main residence exemption states that if the family home is sold there is no CGT on the profit. The main residence exemption only applies to the primary residence of the seller and not, for example, investment properties. Further, the exemption is only available to Australian citizens.
A further exception to CGT is the operation of roll-over relief on investment properties which are transferred by a court order from one spouse to the other. However, this only applies on the inter-party transfer and not if the investment property is later sold for profit.
When calculating the value of assets for a property settlement, the court can take into consideration CGT implications of any asset disposals which may occur, such as an Order to sell an investment property neither party wishes to retain. These considerations fall under s79 and s90SM of the Family Law Act 1975.
The leading case of Rosati v Rosati (1998) provides the following four guiding principles on this issue:
- The extent to which CGT is taken into consideration varies according to the circumstances including the method of valuation applied to the asset; the likelihood of that asset being realised in the future; the circumstances of its acquisitions; and the parties’ intentions for that asset.
- If the Court orders the sale of an asset, or is satisfied that a sale would likely occur, or if the asset is one which was acquired for the purpose of an investment, then, generally, allowance should be made for any CGT payable upon such a sale in determining the value of the asset.
- If principle 2 does not apply, but the Court is satisfied that there is a significant risk that the asset will be sold in the short to mid-term, then the Court, may take into account that risk as a s75(2) factor.
- There may be special circumstances, despite the absence of any likelihood of sale in the foreseeable future, which make it appropriate to take the incidence of CGT into account. The CGT may be taken into account at its full or discounted rate, having regard to the degree of risk of sale and the length of time which is likely to elapse before that occurs.
Shnell & Frey  is a recent case which demonstrated the importance of CGT considerations in a property settlement. At trial the judge rejected the wife’s submission that the CGT liability, in respect of her investment property, should be placed on the balance sheet. The reason for this was that although the wife maintained it was her intention to sell the property within the next two years, during cross examination she conceded that the decision to sell would be made having regard to her financial interests. On appeal it was found that the primary judge had erred in failing to take into consideration the CGT which would result from the future sale of the wife’s property. Specifically, the judge failed to find that the sale of the property would likely occur in the future and that its nature was that of an investment property. The property settlement order was set aside.
Division 7A Income Tax Assessment Act
Division 7A is a part in the Income Tax Assessment Act 1936 which creates a framework for tax payable for payments by a company to a shareholder (or their associate) or similar gains by way of forgiving debts or giving a loan. Where a company pays money to a shareholder directly, this is treated as a dividend and tax must be paid by the recipient as though it were assessable income, up to the 45% income tax rate (plus the 2% Medicare levy) depending on their income. To circumvent the income tax, a Division 7A loan may be entered into, being a loan between the recipient and the company on a ‘commercial’ basis as required by the legislation.
It is important to identify whether any Division 7A loans exist between a party and a related company. A Division 7A liability can be overlooked in family law matters due to the complexity of the asset pool or inadequate bookkeeping by the company (often one of the parties running their own business). Further, the value of a Division 7A loan at the time of Final Orders may be difficult to quantify due to the repayment amount changing depending on the date of repayment(s).
Additionally, an Order transferring property in a family law proceeding may incur a Division 7A liability. Division 7A liabilities are treated just like any liability in the calculation of the asset pool. Depending on the size, a Division 7A loan can significantly impact the value of the asset pool and therefore must be identified and accounted for as a debt.
In a property settlement it is important to consider all tax issues and consequences. If you require assistance with taxation in a family law property settlement, please feel free to contact our office at 03 9670 4122 to arrange an initial consultation.