Trustees receiving a retirement income stream from their SMSF should ensure they are taking advantage of a unique tax deduction available only to them, Melanie Dunn writes.
Are your SMSF clients claiming exempt current pension income (ECPI)? This special tax deduction is available only to SMSFs in pension phase and can significantly reduce a fund’s tax liability. For some funds, claiming exempt income allows the fund to pay no tax.
ECPI allows a fund to claim an exemption from income tax to the extent that fund assets are supporting pension liabilities. The ECPI amount is determined each financial year and deducted from assessable income to reduce the tax liability of the fund.
As at 30 June 2012, more than 167,000 SMSFs were paying a pension. Some of these funds would also have an accumulation account. However, a fund does not have to be solely in pension phase to claim ECPI.
Speaking at last year’s Self-managed Independent Superannuation Funds Association SMSF Forum, Australian Taxation Office (ATO) superannuation assistant commissioner Matthew Bambrick said “we worry about trustees or SMSF professionals who fail to understand their obligations” and went on to say that in 2013/14 the ATO would be “reviewing irregularities in exempt current pension income”. We have seen the ATO continue to emphasise that funds need to be careful when claiming ECPI.
Getting it right
Each SMSF is required to submit a 2013 tax return with the tax office by 15 May 2014. In preparation for meeting this compliance deadline, SMSF accountants should ensure they are confident in:
- assessing whether a fund is eligible to claim ECPI, and
- accurately calculating the amount of ECPI to be claimed.
Whenever an SMSF is paying a pension it is essential to get ECPI right so that the fund does not pay more tax than necessary.
If a fund wishes to claim ECPI it must:
- ensure each pension meets the pension standards, and
- use the appropriate method to accurately calculate ECPI.
Being eligible to claim ECPI
A fund must be paying a pension to claim ECPI, and each pension must meet the minimum pension standards.
The most important requirement of this is to ensure a pension payment is made in form and effect. The ATO is quite clear on this and a simple journal entry doesn’t count.
Example: Meeting the pension standards
Consider an SMSF with two members in pension phase and no longer contributing. John and Mary are aged 67 and 62 at 1 July 2012. John has an account-based pension valued at $240,000 and Mary has a transition-to-retirement pension valued at $120,000.
Schedule 7 of the Superannuation Industry (Supervision) (SIS) Act specifies that John’s minimum pension payment for 2013 should be equal to 3.75 per cent of the pension balance at 1 July and that Mary’s minimum payment is equal to 3 per cent. Mary must also ensure her pension payment does not exceed 10 per cent.
This means John must make a pension payment of at least $9000 prior to 30 June 2013.
Similarly, Mary must make a pension payment of at least $3600 and not more than $12,000 prior to 30 June 2013.
If John and Mary make these pension payments in form and effect, then they would meet the pension standards and be eligible to claim ECPI.
Where a pension does not meet the minimum pension standards in a financial year, it would generally not be considered a pension and would not be eligible for ECPI.
Example: Consequence of not meeting the pension standards
John and Mary set up a monthly direct debit from the SMSF bank account of $750 for John and $300 for Mary into their personal joint bank account. This should ensure they don’t forget to meet the pension standards.
Unfortunately, there was an administrative error with the bank in June and the final payment was not processed until 2 July 2013. This meant John and Mary did not meet their minimum pension requirements in 2013.
As a result, John and Mary’s pensions would cease at 1 July 2012 and the fund would be considered to have paid no pensions during the financial year. In addition, all payments would be treated as lump sums from accumulation.
It means John and Mary would no longer be eligible to claim exempt current pension income and would pay tax on all fund income.
In recognition of the large consequences of not meeting the pension standards, the ATO has considered a concession where the pension standards are not met. This falls under the commissioner’s general powers of administration (GPA) and allows funds to continue to claim ECPI under some circumstances.
Primarily, this concession can be applied to account-based pensions where:
• the pension standards were not met due to an honest mistake or administrative error,
• the shortfall in the pension payments was not more than one-twelfth of the required annual amount, and
• a catch-up payment is made in the following financial year, which is treated for all intents and purposes as occurring in the previous year
This concession can also be self-assessed under limited circumstances.
The GPA concession is backdated to apply to account-based pensions from 1 July 2007. All SMSF accountants and trustees should familiarise themselves with this valuable concession.
Example: Claiming the GPA concession
John and Mary genuinely intended to make the pension payment received on 2 July in the 2013 financial year. It was only due to an administrative error outside their control that the payments weren’t received in time.
They are extremely concerned this error will have serious consequences for their fund. They will need to restart their pensions at 1 July 2013 and will need to pay tax on all fund income.
John and Mary’s accountant, Fred, identifies that the fund is eligible for the GPA concession. The shortfall in the pension payment for John and Mary was only one-twelfth of their annual required amount and the pension payments failed to be made due to an error outside of their control.
With Fred’s assistance, John and Mary receive the GPA concession and their pensions continue. The fund remains eligible to claim ECPI.
Claiming ECPI and getting it right
The SMSF annual return has changed for 2013. Notably there are two changes relating to ECPI:
- the ECPI amount and method is now reported at item 10 in section A, and
- where ECPI reduces assessable income to zero, section B on income does not need to be completed.
ECPI is calculated as the income earned on pension assets. An SMSF’s assessable income is reduced by the ECPI amount, thereby reducing the tax liability of the fund.
Assessable contributions and non-arm’s-length income are not eligible for the ECPI deduction. Where a fund receives concessional contributions, assessable income will never be reduced to zero.
There are two different methods for claiming ECPI. These are specified under section 295.390 and section 295.385 of the Income Tax Assessment Act 1997. They are known as the unsegregated method and segregated method respectively. A fund may use one or a combination of both to claim ECPI. The methods used will depend on the investment decisions made by the trustee and the asset structure of the fund.
Segregated method
If you are unsure whether a fund contains segregated assets, it probably doesn’t. Segregation of assets requires a conscious decision by the trustees and is generally documented as part of the fund’s investment strategy.
Under the segregated method, pension assets are separate to accumulation assets and so income on pension assets is known.
ECPI = income earned on segregated current pension assets
A fund that has only account-based-type pensions is a special case of segregation. The ATO specifies on its website that “a fund solely supporting pension liabilities meets the definition of being a segregated fund” and therefore should claim ECPI using the segregated method.
Neither John nor Mary have an accumulation balance in the fund. All fund assets are supporting their pensions. The fund earned $40,000 in assessable income in 2013. Fred identifies that the SMSF should use the segregated method to claim ECPI. The income earned by the fund is claimed as exempt income.
As the fund has no non-arm’s-length income and received no concessional contributions, there is no other assessable income, so Fred can bypass section B.
Capital gains and losses
Net capital gains form part of the assessable income of a fund, and are part of the ECPI deduction. However, some capital gains and losses should not be included. If an SMSF has segregated pension assets, any capital gains or losses on those assets must be disregarded.
Any capital losses on segregated pension assets must not be offset against any other capital gains earned by the fund and capital losses cannot be carried forward to offset future capital gains. In particular, a fund fully in pension phase cannot carry forward capital losses.
Example: Capital loss
John and Mary incur a $45,000 capital loss during 2013. Fred identifies that as the fund is fully in pension phase, this capital loss is incurred on segregated pension assets and must be disregarded. He reports a $0 net capital gain and does not carry forward the capital loss.
Unsegregated method
The unsegregated method is required where a fund has a pool of assets supporting both pension and accumulation.
No specific assets are set aside to support a pension and so the income on pension assets is not known. The fund must obtain an actuarial certificate to certify the proportion of the income that can be claimed as ECPI.
ECPI = assessable income* x tax-exempt percentage certified by an actuary
*excluding non-arm’s-length income and assessable contributions
Net capital losses incurred on unsegregated assets can be carried forward and net capital gains do form part of the fund’s assessable income.
If a fund in pension phase wanted to carry forward losses, it would need to retain at least a nominal accumulation balance. The fund would then use the unsegregated method to claim ECPI and capital losses could be carried forward.
Example: Unsegregated method and carrying forward losses
In June 2013, John and Mary discuss with Fred that they might need to sell some fund assets in order to have sufficient liquid assets to pay pensions in the next financial year. They notice some assets might be sold at a capital loss and want to ensure that if this happened they could carry forward any capital losses. John and Mary decide that the cost of paying a small amount of tax next year is outweighed by the ability to carry forward any capital losses to reduce tax in future years.
John decided to make a partial commutation of $1000 at 1 July.
At 30 June 2014, John and Mary’s SMSF had incurred a $45,000 net capital loss and there was also other assessable income of $50,000.
Fred is completing the SMSF annual return. He determines that the fund has a pool of assets supporting both pension and accumulation so the fund needs to use the unsegregated method to claim ECPI.
The fund has a net capital gain of $0 and total assessable income of $50,000. The $45,000 capital loss is incurred on unsegregated assets so it can be carried forward to future years to offset future capital gains.
Fred obtains an actuarial certificate that certifies 98.8 per cent of the fund income is exempt from income tax.
ECPI = 50,000 x 0.988 = $49,400
Complex ECPI cases
Some funds employ a strategy where some assets are segregated and some assets are unsegregated. We call this partial segregation.
These funds are eligible to claim ECPI, but they require the use of both the segregated and unsegregated method, which can get quite complex.
For these funds it is particularly important to ensure the fund accurately calculates ECPI and does not pay more tax than necessary.
