Stepping Stones: What Americans in the UK need to know about divorce

UK matrimonial home

Michael and Jane wanted us to calculate the tax implications on the sale of their UK matrimonial home. We helped both parties to understand that Jane would not be subject to UK capital gains tax as the property had been her main residence throughout ownership and is therefore exempt under Principal Private Residence Relief (PPR). However, for Michael, under current rules, as he moved out of the property to go back to the US before the sale, his share of the gain would only be covered by PPR for the period where he owned and lived in the property plus an additional nine-month period of deemed occupation.

Under the UK government’s proposed changes from 6 April 2023, Michael would be allowed to apply the same proportion of PPR on the eventual sale of the property as if he hadn’t moved out, as long as he has not elected another property as his PPR. Jane would continue to qualify for 100% PPR on her share of the gain under the current and the proposed new rules.

In the US, Michael would be subject to US Federal tax of up to 20%, Net Investment Income Tax (NIIT) of 3.8% and California State tax on the gain.

In this case, Michael had owned and lived in the property for two out of the last five years before sale, and therefore could benefit from a $250,000 exclusion to reduce the taxable gain in the US. The US tax above the exclusion is something Michael could not avoid in his circumstances, but in understanding this, Michael and Jane could come to an amicable split in terms of the transfer of sale proceeds from the property.

Michael would also be subject to US income tax of up to 37% on any foreign exchange rate gain arising on the redemption of his mortgage. Michael and Jane had a GBP denominated mortgage, and as it cost fewer dollars to pay off the mortgage than it cost to acquire the liability, Michael realised a foreign exchange rate gain. But Michael was able to utilise his excess foreign tax credits and reduce the US tax liability by $20,000. However, foreign tax credits could not reduce the California State tax charge.

Transfer of shares

As part of the divorce settlement, Jane planned to transfer a portfolio of shares to Michael. Under the current rules in the UK, Jane can only benefit from ‘no gain no loss’ tax treatment on transfer, if the transfer occurs before the end of the tax year in which the separation occurs. 

Under the UK government’s proposed changes from 6 April 2023, Jane would be given up to three tax years after the year they separate in which to make ‘no gain no loss’ transfers. This provides significantly more time to plan.

On the US side, we carried out a review to determine if the portfolio of shares were suitable for Michael to hold as a US citizen. Michael should be wary of investing in non-US collective investment funds, which usually meet the definition of a Passive Foreign Investment Company (PFIC), as on disposal this could result in his US tax bill being substantially higher than initially anticipated due to punitive rates of tax and an interest charge. 

UK pension

Michael wanted to see if there were any tax consequences of transferring a share of his UK pension to Jane. In the UK, many pensions enable a share in pension rights to be transferred on divorce. Jane would receive the pension distributions in the future and would be subject to UK tax. While this is an easy answer for the UK, the pension plan was non-qualifying for US tax purposes and any part of Michael’s pension which was transferred to Jane would be a taxable distribution for US tax purposes.

While there is a possibility of relief for US Federal tax under the US/UK double tax treaty on the transfer from US tax, it would not apply for California State tax purposes. With this knowledge, Michael was able to make an informed decision on whether he would transfer a different asset to Jane.

Assistance on future complications

We helped Michael to avoid future UK tax on the transfer of a cash lump sum to Jane by informing him of the following options: 

1. Use funds situated in the UK as they have already been subject to UK tax so there would be no additional UK tax charge on transfer.
2. If a transfer of offshore funds (which have not previously been subject to UK tax) was made prior to the final order, Michael would have to ensure he did not become UK resident within five years of leaving the UK. This is because the offshore funds contained capital gains, which would be subject to UK capital gains tax if Michael met the temporary non-residence rules. 
3. If a transfer of offshore funds (which have not previously been subject to UK tax) was made after the final order, this would not be a taxable remittance by Michael, as long as he made a transfer to Jane’s offshore bank account and Jane subsequently remitted the funds to the UK. 

We carried out an independent tax assessment, which ensured that there were no conflicts of interest. As we deal with a variety of different clients on a day-to-day basis, we have built up knowledge which assists us with the complexities of certain assets that individuals hold and may transfer as part of a divorce.

Our wealth of experience in divorce allows us to ensure we have the full and complete picture and avoid making assumptions. By ensuring that we have the right information at the start of our engagement, we can meet the strict deadlines the Courts set.

For professional advice tailored to your unique circumstances, please fill out the form below and one of our experts will be in touch to discuss your requirements and how we can help. Please note that our advisory services are charged at our hourly rates and a formal engagement will need to be in place before any advice is provided.

The full Stepping Stones series can be found here.