Deciding whether or not to apply the CGT relief to an SMSF is far from straightforward. Daniel Butler examines some of the intricacies involved in the process.
The transitional capital gains tax (CGT) relief, that is, the cost base reset rules, allows SMSFs to choose to reset an asset’s cost base to the asset’s market value prior to 1 July 2017.
On the surface it may appear an automatic decision to apply the relief, however, there are many intricacies involved requiring consideration before a prudent decision can be made as to which direction to take.
The first of these is, as an adviser, to respect the limits of your advice capability if you do not hold an Australian financial services licence. On the other hand, if you hold a licence, respect the limits on who is qualified to provide tax advice and make sure you are registered with the Tax Practitioners Board if you are providing tax advice.
Other critical factors advisers need to take into account will be outlined in this article.
Do you choose to apply the relief?
Each SMSF in pension mode during the 2017 financial year should be reviewed to determine which SMSFs to review, especially SMSFs with members that have balances in excess of $1.6 million. However, some SMSFs with member balances below $1.6 million may also be entitled to the relief.This depends on a range of factors and choosing to apply the relief will not always be the best decision.
The right decision depends on a proper analysis of the unrealised gains on CGT assets and the costs versus benefits of choosing to apply the relief.
In some cases, the relief can provide great upside, but in others the relief could prove more costly to implement than the advantages.
Indeed, where a member was in receipt of a transition-to-retirement income stream (TRIS) prior to 1 July 2017, there was no need for that member to have more than $1.6 million to obtain CGT relief, provided that member had not satisfied a relevant condition of release, for example, retirement or reaching 65 years of age.
The ATO’s view is the object or purpose of the legislation precludes members with an account-based pension (ABP) below $1.6 million from being entitled to CGT relief. However, there is no provision in the legislation that expresses this view as a criterion and if the legislation intended to preclude this situation, the operative provisions of the legislation should have made this clear.
Does the choice apply to each asset?
The CGT relief applies on an asset-by-asset basis and only applies to assets held in the fund prior to 1 July 2017. Recall Tax Determination 33 confirmed each individual share can be a separate asset. More specifically, the CGT relief will only apply to an asset that is:held by the SMSF on 9 November 2016, and still held just before 1 July 2017.
The ATO states in Law Companion Guide 2016/8: “The choice is made on an asset-by-asset basis. It is not made on an asset-class basis (for example, a fund’s defensive asset class).”
Accordingly, there is a need to drill down to the individual assets in each class of assets held by the SMSF, such as shares, units and similar assets as each share in a company. For example, an SMSF with 100 shares in a company has 100 separate assets and can make a separate election for each asset. However, in practice, we generally only have to examine each ‘tranche’ of shares purchased. Assume these 100 shares on 30 June 2017 have a market value of $6.00 and:
- 50 shares were purchased at $3.00 each on 1 January 2000 (with the serial numbers 1 to 49 inclusive or ‘tranche 1’), and
- 50 shares were purchased on 1 January 2010 for $8.00 (with the serial numbers 50 to 99 inclusive or ‘tranche 2’), then:
- each share in tranche 1 has a capital gain of $3.00, and
- each share in tranche 2 has a capital loss of $2.00.
What are some of the key differences between the segregated and the proportionate CGT relief?
Firstly, the time the cost base reset occurs differs as follows:
- segregated CGT relief: the reset occurs when the asset ceases to be a segregated current pension asset,
- proportionate CGT relief: the reset always occurs immediately before 1 July 2017.
One attraction to applying the segregated CGT relief is the entire capital gain is disregarded in relation to the relevant segregated asset under section 118-320 of the Income Tax Assessment Act 1997 (ITAA 1997). In contrast, under the unsegregated method, a notional capital gain on the non-exempt proportion is assessable and is included in the fund’s assessable income (subject to making a further choice to defer the notional gain until it is actually realised).
If the proportionate CGT relief applies, a deferral of any unrealised capital gain would generally appear to be the most prudent choice compared to paying tax upfront on an unrealised or notional capital gain. However, deferring tax may not always produce the best outcome, as discussed below.
Thus, choosing the proportionate CGT relief may trigger an assessable capital gain. It can also trigger a capital loss.
In contrast, any capital gain or loss is disregarded if segregated CGT relief applied. This is because section 118-320 of the ITAA 1997 provides: “A capital gain or capital loss that a complying superannuation entity makes from a CGT event happening in relation to a segregated current pension asset is disregarded.”
Under the proportionate (unsegregated) method, once any current and prior year capital losses and discount percentages have been applied to the capital gains, the remaining amount is the net capital gain. The net capital gain is included in the SMSF’s assessable income.
If an SMSF is eligible to choose the proportionate CGT relief, then the SMSF will be entitled to treat the asset as sold and immediately reacquired before 1 July 2017, and is therefore required to reflect the non-exempt portion as an assessable capital gain unless a further choice is made to defer the gain. The exempt portion is specified by an actuary in an actuarial certificate pursuant to section 295-390(4) of the ITAA 1997. Thus, to the extent that the net capital gain caused by choosing the proportionate CGT relief is not covered by that proportion, the net capital gain (after the application of capital losses and any CGT discount) is included in the fund’s assessable income under section 6-10 of the ITAA 1997. Naturally, after any deductions, tax offsets and the like have been applied, assessable income can ultimately give rise to an income tax liability.
Example 1 is illustrative.
Thus, if a choice made to defer a notional gain has not been exercised, the non-exempt proportion of that gain is included in the SMSF’s assessable income for 2016/17 (the exempt portion is certified by an actuary, so the non-exempt portion is 1 minus the certified percentage).
In contrast, under the proportionate CGT relief deferral option, the crystallised notional capital gain is subject to a modified version of the method statement in section 102-5 of the ITAA 1997 where it is assumed the fund had no current year or carried forward capital losses and, therefore, these losses are preserved for future years. Section 294-120(4) of the Income Tax (Transitional Provisions) Act 1997 states:(4) The deferred notional gain is the 2016/17 non-exempt proportion of the amount of the fund’s net capital gain for the 2016/17 income year determined on the assumptions that:
(a) subsection (3) of this section does not apply, and
(b) the fund made no capital gains in that income year other than the gain mentioned in paragraph (1)(b), and
(c) the fund made no capital losses in that income year, and
(d) the fund had no previously unapplied net capital losses from earlier income years.
Example 2 illustrates there can be substantially different outcomes resulting from choosing to defer a capital gain compared to disclosing a capital gain in 2016/17.
As discussed above, if the unsegregated method applies, choosing a deferred notional gain can result in a more efficient use of capital losses.
Special CGT modifications
Broadly, the CGT regime is the primary code of taxation for SMSFs and most gains on assets are, subject to a few specific exceptions, on capital account, rather than on revenue account. While not all SMSF assets are on capital account (for example, gains and losses on certain securities and trading stock) and a revenue gain or loss can be derived by an SMSF, most assets are dealt with on capital account, which therefore may provide an opportunity for the one-third CGT discount to apply if the asset has been held for more than 12 months. This means that an SMSF is still entitled to a one-third CGT discount on capital gains on shares, units and stapled securities acquired after 10 May 2011 even if the SMSF is a share trader (or involved in regular investment trading activities) as these items were removed from the trading stock exception for SMSFs in section 295-85 of the ITAA 1997, provided the asset is held for more than 12 months.
Several exceptions to what constitute CGT assets to an SMSF include:
- where the SMSF owned real estate, a share, unit or a stapled security as trading stock as at 7:30pm Australian Capital Territory time on 10 May 2011 (Tax Laws Amendment (2012 Measures No 1) Act 2012 schedule 2 item 6), and
- the asset is a debenture stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security, deposit with a bank, building society or other financial institution, a loan or some other contract under which an entity is liable to pay an amount (section 295-85(3)(b) of the ITAA 1997).
Furthermore, some tax advisers are surprised to learn SMSFs do not have any pre-CGT assets (note the CGT regime commenced on 19 September 1985 for non-superannuation taxpayers) and all assets of regulated and complying superannuation funds were brought into the CGT regime on 30 June 1988. Superannuation funds with assets owned prior to 1 July 1988 were given a choice to adopt the cost base or market value of such assets on 1 July 1988.
The CGT relief also only applies to CGT assets owned by an SMSF. Thus, investments held by an SMSF via a company or trust do not obtain any CGT relief. Example 3 illustrates this issue.
It should be borne in mind that the CGT relief provisions can nonetheless provide relief to an SMSF’s unit holdings in a unit trust where the units carry a significant unrealised capital gain due to having a reduced cost base pursuant to CGT event E4.
As you will gather from the above brief summary, there is considerable complexity and unfortunately limited time to become familiar with and implement the CGT relief. Advisers must start taking action now and notify clients of what must be attended to and by when as a choice to obtain CGT relief must be made by the lodgement date of the SMSF’s 2017 financial year tax return.