Applying CGT relief for an SMSF should not be regarded as an automatic decision due to the intricacies involved, writes Meg Heffron.
There is no doubt the aspect of the 2017 super reforms that has caused the most angst among SMSF practitioners is the relief on capital gains tax (CGT). It’s unsurprising – the legislation is unnecessarily complex with a few ‘gotcha’ moments, and the ATO has taken a fairly hard line on who it believes is eligible and certainly in my view it has exceeded its brief.
But from an implementation point of view, the best news about the CGT relief is that not everything has to be done by 30 June 2017.
In fact, one of the most commonly misunderstood features of the relief is that the decision to opt in or not can be deferred until the 2016/17 income tax return is prepared. It would be entirely legitimate for a trustee to lodge the return in May 2018 and only decide then which assets should be selected for relief and which should not. In fact, they can even take into account what has happened since 1 July 2017. Has the asset subsequently been sold in January 2018? Which produces the best result – opting in or not?
In this article, we use a case study to explore some of the decisions a typical client and their adviser might need to consider in implementing their decisions around CGT relief during 2017/18.
Case study
Alison and James are 52 and 59 respectively. At 30 June 2016, their balances were as per Table 1.At 9 November 2016, the position was similar – during the year the fund received contributions for both members and made pension payments from James’s transition-to-retirement pension.
The SMSF has a mixture of shares and term deposits plus a single property valued at $1.5 million at 30 June 2017. All of their fund’s assets are worth more than they paid for them. The property was purchased years ago for only $300,000 and the value has taken off since then. They intend to sell it in the next few years.
None of the SMSF’s assets have ever been specifically set aside to support James’s pension – they are all pooled between all accounts.
Both James and Alison are working full-time and have no intention of retiring until they are 65. Alison will obviously be eligible for a transition-to-retirement income stream (TRIS) in around eight years when she turns 60 and might start one then if they need the cash flow, but not necessarily.
They don’t currently need the cash flow from James’s TRIS – they really only started it because it was a great tax outcome for them. James intends to commute it on 30 June 2017. They are contributing the maximum $35,000 employer contributions and occasionally make non-concessional contributions.
Regardless of the CGT relief method that applies to an asset, that is, the proportionate method or the segregated method, each method involves a notional sale and immediate reacquisition of an asset at market value, thereby resetting the cost base to the market value at a particular date. This notional sale gives rise to an actual CGT event and the capital gain realised as a result of the cost base reset is subject to tax in the usual way. And as it is an actual CGT event, the 12-month CGT discount period restarts from 1 July 2017.
How does the CGT relief apply to this fund?
Firstly, the method that applies to them is the proportionate method. This is because at 9 November 2016:the fund had a mixture of pension and accumulation accounts, and James is affected by the changes. Even though he has less than $1.6 million in his pension, his pension is a TRIS and the investment income generated by the assets that support it will no longer be partly exempt from tax. The position would have been completely different if his pension had been a full account-based pension as – in the ATO’s view – James would not have needed to take any action to comply with the new rules.
They can choose to reset the cost base of all assets at 30 June 2017. Note that:
- the date is 30 June 2017 regardless of when James commutes his pension – and this could be before or after 1 July 2017, and
- it applies to all assets even though only part of the fund was in pension phase (there is no need to try and identify $1.4 million worth of assets that equate to James’s pension).
In the case of the property then, if they elected to reset the cost base from $300,000 to $1.5 million, they would realise a capital gain of $1.2 million.
How much of that capital gain is taxable?
Let’s say the actuarial tax-exempt percentage for 2016/17 is 53 per cent (meaning 47 per cent of assessable investment income, including capital gains, is taxable). The taxable component of the capital gain would therefore be calculated as: $1,200,000 x 2/3 (that is, less a 1/3 discount as the property has been held for longer than 12 months) x 47% = $376,000
Just like a normal taxable capital gain, tax is payable in the year the gain is realised, that is, with the 2016/17 tax return in this case. However, a special rule lets them choose to defer the inclusion of this $376,000 taxable capital gain in the fund’s tax return until a later year – the year in which the property is sold. If they sold the property in 2022/23, for example, they would include the $376,000 deferred taxable capital gain in the 2022/23 tax return and pay tax on it then (note that no further CGT discount would apply to the deferred taxable capital gain in 2022/23, nor would the actuarial tax-exempt percentage for 2022/23 – each of these tax concessions only applies once, in respect of 2016/17).
Importantly, by opting in to the relief, they don’t have to pay tax on the rest of the capital gain built up before 30 June 2017 (that is, $1,200,000 x 2/3 x 53% = $424,000). This is true even if the fund has absolutely no pensions at the time they sell the property – they are still effectively getting the benefit of being partly in pension phase back in 2016/17.
But should they opt in for the relief?
Alison and James are in a tricky position.Their actuarial tax-exempt percentage for 2016/17 is quite low because only James is in pension phase.
What could their future look like?
If they do keep working until 65 and don’t meet any of the superannuation definitions of retirement in the meantime, they won’t be eligible for a full (retirement-phase) account-based pension until they turn 65.For the next six years then, their fund will be back to paying tax in full. For the seven years between James’s 65th birthday and Alison’s, their fund will be partly tax-free. By the time they are both 65, the SMSF is likely to have grown, but let’s say the position looks something like this:
James starts a retirement-phase pension at 65 (in six years’ time) when his balance is $1.7 million (at the time the pension transfer cap is $1.7 million). He will be able to move entirely into pension phase.
Alison starts a pension several years later when her balance is $2.2 million (remember, this is some 13 years away) at a time when the pension cap is $2 million and hence she has a pension of $2 million and an accumulation balance of $200,000.
Let’s say their actuarial percentage eventually gets up to 95 per cent.
What would happen if they sold the property for $2 million and they had opted in for the CGT relief back in 2017?
The tax to pay would be as per Table 2.
What if they hadn’t opted into the relief?
($2m – original cost of $0.3m) x 2/3 x (1 – 95%) x 15% = $8500
Why does the CGT relief look so bad for them?
The CGT relief is unfavourable for them because in the future their actuarial tax-exempt percentage will be much higher than it is in 2016/17 (that is, 95 per cent versus 53 per cent). Electing to apply the relief locks them into paying tax on gains built up before 2016/17 that they don’t ultimately need to pay.
What if they had sold the property in 2019/20 for $1.6 million?
(Remember at this time there are no retirement-phase pensions in place at all. Even if James left his transition-to-retirement pension in place, it would not give the fund a tax exemption on its investment income.)If they had opted in to the relief, the tax to pay would be:
15% x $376,000 + ($1.6m – $1.5m) x 2/3 x 15% = $66,400 And if they hadn’t opted in:
($1.6m – $0.3m) x 2/3 x 15% = $130,000
In other words, the considerations they might have are as follows:
- if there are assets with large accrued gains at 30 June 2017 and they intend to sell the asset soon (before their actuarial percentage is very high), they would opt in to the relief, and
- if not, don’t opt in to the relief.
James and Alison might be very deliberate here and only choose to opt in for the CGT relief on their property (given their plans for its sale) – and not the shares.
There is nothing to prevent them doing that and choosing to opt in for some assets and not others.
What if James’s accumulation balance had been a much more significant part of the fund and he had converted it to a pension, increasing the actuarial percentage for 2016/17?
Table 1
Table 2
This would be fine (assuming he had a legitimate reason for starting the pension and it wasn’t purely driven to maximise the CGT relief). A higher actuarial tax-exempt percentage would simply mean a lower deferred taxable gain on any assets for which he opted into the relief.
What if Alison had been eligible for a pension and they had converted the whole fund to pension phase on 1 December 2016?
They would have lost the CGT relief entirely as their fund would have become segregated – that is, solely supporting pension balances at that time. The relief is only available under the proportionate method if the assets don’t become segregated between 9 November 2016 and 30 June 2017.
The CGT relief is not available for them on the segregated method either because they weren’t segregated on 9 November 2016.
What if James hadn’t been intending to switch off his transition-to-retirement pension (and so hadn’t needed to take any action to comply with the new rules)?
That’s fine – the CGT relief still applies because he has a transition-to-retirement pension. He can keep it – or stop it – either way, the CGT relief is available.
Conclusion
When it comes to CGT relief, there will still be plenty to think about in 2017/18 – the implementation for those changes will start in earnest as soon as accountants start lodging 2016/17 returns. Perhaps for once clients will be clamouring for late lodgement, rather than yesterday.
