Grant Abbott concludes his four-part series on the compliance issues and benefits of using reserves in an SMSF.
This is the final instalment of the guide to SMSF reserves – my treatise on the use and misuse of reserves in an SMSF. They can be a blessing, but if not properly used or documented they can turn into a time bomb. For example, the typical means of building a reserve is from the allocation of earnings prior to any declaration of an investment return. Superannuation Industry (Supervision) (SIS) Regulation 5.03 states:
1. The trustee of an accumulation fund or an approved deposit fund that maintains reserves must determine the investment return to be credited or debited from time to time to a member’s benefit (or benefits of a particular kind) in the fund, having regard to:
- the return to the fund on investments; and
- the extent to which the costs of the fund exceed (or fall below) the aggregate of the costs charged to member’s benefits under regulation 5.02; and
- the level of the reserves of the entity.
However, earnings normally allocated to a member’s account would never be treated as a concessional contribution, a danger of which to be aware when taking revenue to a reserve before allocating to the fund’s specific members. This is flexibility with danger and as such should only be used by the most expert SMSF advisers.
In this final article we will look at this issue and consider the SIS Act 1993 and, more importantly, given the danger above, the Income Tax Assessment Act 1997 (ITAA) and attendant regulations.
1. The SIS Act 1993
We considered the SIS Act and the Australian Prudential Regulation Authority’s (APRA) view on the establishment of SMSF reserves previously and the need to have specificity in terms of reserves, such as an investment reserve or pension reserve. A general reserve is not suitable according to APRA guidelines. Apart from the guidelines, section 115(1) of the SIS Act 1993 provides:
1. A trustee of a superannuation entity may maintain reserves of the entity.
2. Subsection (1) does not apply if the governing rules of the entity prohibit the maintenance of reserves.
Apart from this short reference to reserves in the legislation, the regulations include a requirement in division 7.2 of the SIS Regulations requiring a mandated allocation – taking away some of the desired flexibility of a reserve.
Sub-regulation 7.08 – Contributions to be allocated to members
In that regard if the trustee of an accumulation fund receives a contribution in a month, the trustee must allocate the contribution to a member of the fund:
a. within 28 days after the end of the month; or
b. if it is not reasonably practicable to allocate the contribution to the member of the fund within 28 days after the end of the month — within such longer period as is reasonable in the circumstances.
The contribution regulation was introduced in 2004 to ensure that contributions made directly into a reserve were not being stored to circumvent the superannuation surcharge – a precursor of the concessional contribution caps. Although the superannuation surcharge is now gone, the regulation is important to the operation of the concessional and non-concessional contributions tax rules. If it were not for SIS Regulation 7.08, a trustee would be able to store both concessional and non-concessional contributions in a contributions reserve account until such time as they were needed. It would only be at that time they become concessional or non-concessional contributions.
2. Reserves and part 3-30 of the ITAA 1997
In drafting the revision to the superannuation laws in 2007, the legislators crafted tight rules around the use of reserves. They had learned from their experiences with the superannuation surcharge and built upon the prior surcharge reserving rules. There are now two sets of reserving rules that are to be found in the excess contributions tax laws.
i. Non-concessional contributions and reserves
The definition of a non-concessional contribution in section 292-90(4) (a) of the ITAA includes an amount in a complying superannuation plan that is allocated by the superannuation provider in relation to that plan for you for the year in accordance with conditions specified in the regulations.
Income Tax Regulation 292-90.01 deals with allocations from a reserve account. The operative provision is sub-regulation (2) which provides:
2. Subject to sub-regulation (3), an amount that:
a. is allocated under division 7.2 of the SIS Regulations; and
b. is not assessable contributions under subdivision 295-C of the act;
is to be treated as having been allocated by the superannuation provider in a way that is covered by paragraph 292-90 (4) (a) of the act.
Excluded from the non-concessional contribution definition are allocations that represent:
- the government co-contribution,
- rollover superannuation benefits,
- capital gains tax exempt non-concessional contributions,
- personal injury exempt non-concessional contributions,
- foreign superannuation fund transfers where the assessable amount has been transferred to the fund, and
- the tax-free component of a termination payment upon retirement.
To my knowledge the use of a contributions reserve to house non-concessional contributions is uncommon in an SMSF, unless they are excessive concessional contributions.
ii. Concessional contributions and reserves
The big sting in the reserving rules is on the concessional contribution side. In that regard, concessional contributions are those contributions assessable to the trustee of the fund as defined by section 295-25 of the ITAA. Allocations from a reserve are also taken to be concessional contributions, subject to the exceptions below.
The concessional contributions cap for the 2015/16 income year is $30,000. For over 50s it is $35,000. From 1 July 2013 excess contributions tax is at the individual’s marginal rates. Prior to 1 July 2013 where the member exceeds the concessional contribution cap, they are to pay excess concessional contributions tax at a rate of 31.5 per cent. Excess concessional contributions are also deemed to be non-concessional contributions under section 292-90(1) (b).
At this time, non-concessional contributions in excess of the caps (currently $180,000 or $540,000 with the three-year bring-forward rule) can at the election of the member be returned at no penalty. Failure to elect within the time period concerned renders the non-concessional contributions subject to tax at the highest marginal tax rate, so for excess concessional contributions exceeding the non-concessional cap huge taxes may be payable.
Income Tax Regulation 292-25.01 deals with allocations from a reserve account, including them as concessional contributions. There are three key provisions – an allocation from a contributions reserve, an allocation from other reserves and an allocation from an income stream reserve.
i. Allocation from a contributions reserve
Sub-regulation 292-25.01(2) provides:
2. Subject to sub-regulations (3) and (4), an amount that is:
a. allocated under division 7.2 of the SIS Regulations (see above) and
b. an assessable contribution under subdivision 295-C of the act; is to be treated as having been allocated by the superannuation provider in a way that is covered by subsection 291-25 (3) of the act.
This means all allocations from a concessional contributions reserve are a concessional contribution and remember they must be allocated in the month following the allocation to the reserve.
ii. Allocations from other reserves
The concessional contributions tax rules in relation to allocations from reserves have been written to include all allocations to a member of the fund with some exceptions. The exceptions are as follows:
Allocation on a fair and reasonable basis
Sub-regulation 292-25.01(4) (a) provides that an allocation from a reserve account is not a concessional contribution if:
i. the amount is allocated, in a fair and reasonable manner:
a. to an account for every member of the complying superannuation plan; or
b. if the member is a member of a class of members of the complying superannuation plan, and the amount in the reserve relates only to that class of members — to an account for every member of the class; and
ii. the amount that is allocated for the financial year is less than 5 per cent of the value of the member’s interest in the complying superannuation plan at the time of allocation.
The explanatory memorandum provides further insight on what is fair and reasonable:
“The first condition is that the amount is allocated to all members of the fund, or class of members to which the reserve relates on a fair and reasonable basis. In determining what is fair and reasonable it is necessary to have regard to members’ proportionate interests in the superannuation plan. It would ordinarily be expected that the allocation would be in proportion to the existing interests of the members, so that particular members are not favoured over others.”
iii. Allocation from a pension reserve
Sub-regulation 292-25.01(4) (b) provides that an allocation from a pension reserve account is not a concessional contribution in three instances. However, the following condition must first be met:
i. the amount is allocated from a reserve used solely for the purpose of enabling the fund to discharge all or part of its liabilities (contingent or not) as soon as they become due, in respect of superannuation income stream benefits that are payable by the fund at that time.
This condition mirrors the first part of the definition for “segregated current pension assets” in section 295-385(3) of the ITAA. Accordingly, where the trustee maintains a reserve to fund current pensions then an allocation from that reserve to a member is not a concessional contribution in the following three cases:
ii. When the allocation is used by the trustee to satisfy an income stream liability of the fund paid during the financial year.
iii. When the allocation is used in the acquisition of another income stream on the commutation of a prior income stream by the member.
iv. Where a member in receipt of an income stream dies and the allocation is applied by the trustee to fund an income stream for a dependant or paid as a lump sum to a dependant, non-dependant or the deceased member’s legal estate.
3. Application to the case study
So back to our case study. The Jones SMSF was established in 1998. Since that time the financial planner and accountant of the fund have been allocating 20 per cent of the fund’s earnings to an investment reserve created at the time. A separate investment strategy for the reserve has been completed by the SMSF’s financial planner investing in an Australian shares exchange-traded fund and for the year ended 30 June 2015 the SMSF’s audited accounts show an investment reserve of $130,000.
There are two members of the fund – Sam and Pat Jones – both aged 56, with Sam in receipt of a transition-to-retirement income stream (TRIS) valued at $400,000 with a tax-free component of 60 per cent and a taxable one of 40 per cent. Sam also has a lump sum accumulation account with $120,000 that is all taxable. Sam has his own business and will continue to contribute to the SMSF whenever possible.
Pat is retired and has an account-based pension of $350,000 ( with a 50 per cent tax-free component and 50 per cent taxable one).
The fund runs a pooled investment strategy for all superannuation interests, with an asset allocation of 70 per cent to Australian equities and 30 per cent to cash.
There are a number of reserve aspects in relation to the case study to be considered:
1. An allocation from the investment reserve of no more than 5 per cent to be allocated across all members interests will not be a concessional contribution – in this case we will make it 4.5 per cent. This would enable the trustee of the fund to allocate $18,000 to Sam’s TRIS, the reserve allocation would follow the same proportion as the underlying pension and $5400 to his accumulation account, which would all be taxable component. For Pat’s pension of $350,000 a 5 per cent allocation would be $15,750 and again following the pension proportion of 50 per cent tax-free and 50 per cent taxable component.
As these amounts are all equal and less than 5 per cent, they will not be concessional contributions and will reduce the investment reserve by $39,150.
2. An alternative strategy is a transfer from the investment reserve of an amount to a special purpose pension reserve. As the fund is mainly in income stream and pensions, the investment reserve may be better placed into a pension reserve. The transfer between reserves is not an allocation and thus not a concessional contribution. In terms of a properly constructed pension reserve, the trustee may wait until the death of the member and allocate at that time as a lump sum and it will not be treated as a concessional contribution courtesy of the exemption for pension reserve allocations. Likewise, Pat may take a pension payment of $50,000 for the current income year and the trustee may allocate $50,000 to her pension account and it would not be considered as a concessional contribution.
