21 AUG 2018
On 31 December 2018 the US has a significant change in its tax treatment of spousal maintenance, alimony payments. It is being resisted by many US family lawyers. Yet the UK made a similar change in 1989 and has been mostly very welcomed. However, it can still cause problems for international families as highlighted in a recent English High Court case. This article explains the English experience before and after 1989 in order to share with family law practitioners worldwide.
Tax and spousal maintenance obligations for international families: the UK experience of the imminent US changes
In this article, for ease of reference, I have assumed that it is the husband who is paying the maintenance to his wife. In practice this is not necessarily so, but the principles outlined in this article nevertheless apply.
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In the UK, spousal maintenance, sometimes known abroad as alimony, and child support are an entirely tax neutral event. It is paid out of taxed income and is received free of income tax. But this has been the position only since 1989, the Finance Act 1988, when the then Chancellor of the Exchequer, Nigel Lawson, made significant changes to the UK tax regime.
The US is making this change as at 31 December 2018. The Tax Cuts and Jobs Act 2017, signed into law by President Trump on 22 December 2017, applies to divorce or separation orders made after 31 December 2018 or modified after that date. Section 11051 is specifically entitled: 'repeal of deduction for alimony payments'. At the moment, as with the UK until 1989, in the US the paying spouse can deduct alimony and support maintenance payments against taxable income. The receiving spouse has to pay income tax upon it.
There is much commentary from US lawyers that this change will lead to more litigation and judges may be less willing to make such generous maintenance orders knowing that the paying party cannot set against their higher rates of tax. The ABA has been considering a resolution to oppose it.
So what was the English experience? I remember the tail end of the previous tax regime, having been working in so-called big money divorce cases from 1985.
It was generally regarded as highly cumbersome. It made working out the divorce settlement much more complicated. If the maintenance was of a certain level above the tax-free band, the recipient worried about what tax they would have to pay and what would be the net of tax income in their hands. The paying party would work out the net impact of any proposed maintenance amount by going through what was then a number of higher rate tax bands. Of course when acting for the recipient party we knew the paying party would have the benefit of the tax relief against higher rates of tax and so we would ourselves work this out in arguing for a higher amount than the recipient would otherwise have received out of taxed income. It was cumbersome in that the paying party had to fill in a form, which, from recollection and experience of having to complete them as an assistant solicitor, was known as R185 and give it to the recipient party. The recipient needed this to give to their own tax office to show that they had received spousal maintenance as taxable income. Many of these forms went astray and were simply not completed, often causing prejudice to one or both parties and certainly changing the net effect of the maintenance obligation.
It also was very discriminatory in favour of separated and divorcing couples. After it was established in 1980s case law that one could bring financial claims against oneself, it made perfect sense for paying parties to seek court orders as quickly as possible so that they could set off maintenance payments against their higher rates of tax. Given that child maintenance included school fees, there was one group of parents paying school fees out of taxed income and another group, divorced or separated from the other parent, able to set off the school fees against higher rates of tax. This was completely unfair. Similarly housekeeping paid in an intact marriage had no tax implications but when paid by a court order gave significant tax benefits. This was one primary reason for the abolition. It was perceived as unfair and discriminatory on those who are married.
US lawyers are saying that judges will be less generous in the future. My recollection is that there was a time during which the impact of these changes was carefully considered. But I think it was only a year later when most realised the significant benefits of this much easier process. When working out maintenance payments, no consideration has to be given for the fiscal consequences.
It is a quirk that UK tax law still allows what was known as maintenance payments relief. But it is in very restricted circumstances. Either the paying party or the receiving party must have been born before April 1935, namely they would be 83 by now. It must be maintenance of a spouse or civil partner, or for children under 21 which some might suggest stretches biological expectations.
However if either party is taxed abroad there are complications with this tax neutral element of maintenance. Apart from the US, there are a number of countries where maintenance payments are treated as taxable income and the recipient may find themselves paying tax upon it and/or where the paying party can still deduct against higher rates of income tax. This needs to be taken into account in any divorce settlement both at the outset and on any review or variation. These countries include Ireland, Italy, Portugal, Netherlands and Belgium within the EU and others around the world. A number of countries including Australia are the same as the UK and treat maintenance payments as a tax neutral event.
This issue featured in a recent High Court decision, Harris v Harris (2018) EWHC 1836, of Cohen J. The former wife was in Belgium and receiving £850 per month but subject to Belgian tax of about 40% meaning she only received £509 per month. The trial judge engaged in the complex logistical calculation which was commonplace before 1989 and worked out what she needed to produce the amount of maintenance required net of Belgian tax. The major distinction with 1989 of course is that the paying former husband in this case was paying out of taxed income. Of course double tax treaties need to be taken into account which only compounds the complexities of these calculations. Nevertheless they must be taken into account for any international family.
It may be that the US, with perhaps less international family law traffic than the UK, will have less problems with either party having a different fiscal situation in their country. The US changes only apply to new orders, although this incorporates modifications. Undoubtedly there will be a new mindset in thinking through appropriate quantum of spousal maintenance but the process is likely to be far easier and simpler for all involved. It certainly also removes the fiscal discrimination in favour of divorced and separated parents.
It also brings home again to all family law practitioners that the fiscal aspects must always be brought into account for international families in financial settlements on relationship breakdown.