The new rules regarding exempt current pension income are complex with significant flow-on effects to other SMSF areas. Daniel Butler and William Fettes explain.
Due to the complexity of the rules and the importance of complying with the law in relation to the pension exemption, we examine the two methods for calculating exempt current pension income (ECPI) in respect of account-style pensions (that is, account-based, allocated and market-linked pensions) under the Income Tax Assessment Act 1997 (ITAA 1997) in the SMSF environment. A sound understanding of the ECPI method is required to manage and correctly apply the transitional capital gains tax (CGT) relief provisions in relation to the 2017 financial year.
The main ECPI provisions are set out in sections 295-385 and 295-390 of the ITAA 1997. These provisions provide the foundation for working out how much of the ordinary and statutory income of an SMSF (that is, income other than assessable contributions and non-arm’s-length income) is exempt from tax when the fund is paying a pension (we generally refer to the term pension for simplicity as the correct tax term is superannuation income stream).
Naturally, it is important to understand both the segregated and the unsegregated methods of calculating ECPI to ensure SMSFs are appropriately treated for tax purposes where one or more pensions are being paid. This understanding is also essential for compliance with the transitional CGT relief provisions. Unless the two ECPI methods are correctly understood and applied, SMSFs may miss out entirely on CGT relief.
From 1 July 2017, a pension must be in retirement phase to obtain an ECPI exemption. A transition-to-retirement income stream (TRIS) will no longer be entitled to an ECPI exemption from 1 July 2017 as a TRIS will no longer be eligible to be in retirement phase.
We also note the law and actuarial, industry and ATO practice differs considerably. Thus careful analysis is required to ensure the correct application of the law is made in each instance.
The unsegregated method is the most commonly used method for determining ECPI. Under this method, no particular SMSF assets have been set aside or identified as supporting pensions paid by the fund, and the fund’s exemption is calculated using the following prescribed formula:
Average value of current pension liabilities
Average value of superannuation liabilities
- the numerator averages the current value of pension liabilities in that financial year (this does not include liabilities for which segregated current pension assets are held), and
- the denominator averages the value of the fund’s current and future superannuation benefit liabilities (this does not include liabilities for which segregated current pension assets or segregated non-current assets are held).
Under the unsegregated method, an actuary must certify the exempt proportion of assessable income of the fund each financial year in accordance with the above formula. In applying the formula, the actuary will broadly have regard to the average balance, contributions, earnings and the days during a financial year that the average balances are held in the fund.
The unsegregated method does not require any special changes to a fund’s accounting system. There is generally an actuarial certificate and possibly some other supporting records such as trustee resolutions consistent with a fund using the unsegregated method.
The segregated method is where the investments of a fund are allocated between assets that are being used solely to provide pensions (these assets are known as segregated current pension assets) and other assets (such as assets in accumulation phase).There are broadly two ways that ECPI segregation could apply:
- active or actual segregation whereby certain fund assets are specifically set aside to fund current pension liabilities, or
- deemed or de facto segregation whereby all of the assets of the fund are supporting current pension liabilities.
Active segregation is not that common and a considerable number of SMSFs are segregated as a result of being deemed segregated (that is, 100 per cent of the fund’s assets are funding pension liabilities).
Active segregation depends on appropriate record-keeping. For example, it would be best practice to have:
- trustee resolutions recording:
- the assets that have been specifically identified as funding the pension liabilities, or
- the specific assets that are not funding pension liabilities, for example, an SMSF may have all of its assets funding a pension apart from certain assets that are not funding a pension. It may be easier to record the non-pension assets (for example, cash in a separate bank account) rather than the pension assets, which may be far more comprehensive like a diversified portfolio of investments,
- assuming less than 100 per cent of the fund is segregated – accounting records or computer systems that are set up to track the income/losses, capital gains/losses, tax entitlements and other aspects relating to the assets funding pensions (or as noted just above, the non-pension assets if this is easier), and
- possibly other documentation that evidences segregation, including a statement or letter of advice, financial statements, tax returns or a fund’s investment strategy.
As already noted, deemed segregation is possibly the more common form of ECPI segregation and there may not be any records evidencing this type of segregation.
As discussed above, under active segregation, the fund’s accounting system needs to track the income/losses, capital gains/losses, tax entitlements and other aspects relating to the assets funding pensions. More specifically, the accounting system needs to be able to track the income/losses, changes in market values of assets, gross and net capital gains and franking offsets, foreign tax credits and other tax attributes of the fund’s segregated assets.
In contrast, under deemed segregation, there is no specific tracking needed as 100 per cent of the fund’s assets are funding pension liabilities at that time.
Can segregation be for part of a financial year?
The ATO has confirmed an SMSF can be segregated for part of a financial year. The following is a recent extract (with minor edits) from the ATO’s website (reference QC 47029):“Where an SMSF is paying only a pension prescribed by the superannuation regulations, most commonly an account-based pension, including a TRIS from segregated assets, an actuarial certificate is not required. This exemption applies to an SMSF, even where it commences to pay an account-based pension during the year. The only exception is where the SMSF is also paying pensions not prescribed by the regulations, where the fund can still have segregated assets but will be required to get an actuarial certificate.
This change [in ATO view] will be reflected in a soon to be published addendum to TD 2014/7.”
However, some may get the impression from other ATO materials that segregation for an entire financial year is required if they review this extract from the ATO’s website (reference QC 21546):
“Where all SMSF fund members are receiving a pension, for the entire year of income and the combined account balances of these pensions is equal to the market value of the fund’s total assets, in effect all assets of the fund will meet the requirement of being ‘segregated’ as they have the sole purpose of paying super income stream benefits. In this situation, the ATO will accept that the SMSF is not required to identify individual assets as being dedicated to funding a super income stream benefit. You will not need to obtain an actuarial certificate to claim ECPI if:
- you want to claim the tax exemption using the segregated assets method,
- the assets were segregated for the entire year of income,
- at all times that pensions were payable during the income year, the SMSF only paid allocated pensions, market-linked pensions or account-based pensions, and no other type of pension.”
We note section 295-385(3) of the ITAA 1997 recognises that assets can be segregated assets for part of a financial year as the provision states “at a time assets are solely funding pensions”, provided an actuarial certificate is obtained.
In contrast, section 295-385(4) provides that segregated assets supporting account-style pensions “at a time” do not require an actuarial certificate provided subsection 295-385(5) is satisfied. It is interesting to note that section 295-385(5) provides that subsection 295-385(4) “does not apply unless, at all times during the income year” the liabilities are in respect of account-style pensions.
The ATO at  in Taxation Determination TD 2014/7, while not expressly confirming that segregation for part of a financial year is available, states:
“42. Subsection 295-385(4) applies, subject to segregation requirements, when the liabilities of the fund to pay superannuation income stream benefits during an income year are liabilities to pay only superannuation income stream benefits that are prescribed by the regulations.”
As noted above, the ATO website extract does confirm segregation for part of a financial year applies (reference QC 47029). The ATO issued the above paragraph 42 as an addendum to clarify this position. However, it is only by contrasting the wording in the current paragraph 42 in the addendum to the prior wording in the original determination, that provides a clue to the ATO’s revised position where it accepts segregation for part of a financial year.
“42. Subsection 295-385(4) applies when the liabilities of the fund are to pay only superannuation income stream benefits prescribed by the regulations for the whole income year and there are no liabilities to pay any other kind of superannuation income stream benefits. This requirement is clearly stated by subsection 295-385(5).”
Thus, based on the ATO materials, we conclude that:
- section 295-385(3) supports segregation for part of a financial year, but this subsection is relevant where an actuarial certificate is obtained, for • example, if the fund has lifetime or life expectancy pensions, and
- sections 295-385(4) and 295-385(5) support segregation for part of a financial year where the pensions are account-based pensions or TRISs.
We will now examine several examples.
Example: a segregated fund
The Charlie Super Fund is entirely in accumulation phase for the first four months of the 2017 financial year. Charlie is the sole member of the fund, which has $1.65 million in accumulation. Charlie, however, decided to commence a pension on 1 November 2016 so he would be entirely in pension mode for the remainder of 2016/17. The segregated CGT relief applies where an asset of the fund was segregated on 9 November 2016. This is the case as the fund was deemed to be segregated on that date under the ATO view that all of the fund’s assets were supporting pension liabilities at that time. Further, there is no need for an actuarial certificate having regard to the above analysis as the ATO accepts that segregation for part of a financial year applies.If an SMSF was segregated for part of a financial year and then unsegregated for the remainder of that financial year (that is, segregated for part of the financial year and unsegregated for part of the financial year), an actuarial certificate would be required to claim an ECPI exemption under sections 295-390(3)-(5), but the segregated assets are excluded. The formula in section 295-390(3) excludes segregated current pension assets from the numerator and segregated non-current assets from the denominator.
Example: an unsegregated fund
Mrs Spin, being the sole member of the Spin Super Fund, is entirely in pension mode, so deemed segregation applies, from 1 July 2016. Mrs Spin has $1.8 million in an account-based pension. However, she makes a contribution on 20 June 2017 that converts her SMSF to an unsegregated fund. An actuarial certificate is required and, broadly, the earnings in respect of the segregation period for part of the financial year, that is, from 1 July 2016 to 19 June 2017 inclusive, should be exempt. Broadly, the earnings from 20 June 2017 to 30 June 2017 (inclusive) will be exempt to the extent of the unsegregated proportion as certified by an actuary.Now, analysing the CGT relief, the segregated CGT relief applies where an asset of the fund was segregated on 9 November 2016. This is the case as the Spin Super Fund was deemed to be segregated on that date under the ATO view that all of the fund’s assets were supporting pension liabilities at that time.
Since an actuarial certificate is required for the Spin Super Fund’s ECPI, many may be led to believe the unsegregated CGT relief applies since there is an amount of unsegregated ECPI. In particular, one key criterion of the proportionate CGT relief applying is section 294-115(1)(b) of the Income Tax (Transitional Provisions) Act 1997 (ITTPA), which provides “the proportion mentioned in subsection 295-390(3) of the Income Tax Assessment Act 1997 in respect of the fund for the 2016-17 income year is greater than nil”.
ATO view on the segregated method
The ATO holds the view an SMSF that is solely in pension phase at any time during a financial year has segregated current pension assets at that time, even if this was one day (for the purposes of section 295-385). This view gives rise to no great issue for SMSFs that are 100 per cent in pension phase for the entire financial year. However, we understand it would potentially give rise to considerably more work and costs (especially by advisers, such as accountants and actuaries), where an SMSF may, for example, be partly in accumulation phase and partly in pension phase for a period of a financial year (say where only one member is in pension phase), then becomes entirely in pension phase for a period of the same financial year (say where the second member commences a pension), and then changes back to partly in accumulation phase and partly in pension phase for a further period of the same financial year (say after a contribution is received prior to 30 June).We understand the ATO/strict legal view differs from current actuarial practice, where actuaries generally treat a fund as being unsegregated for the entire financial year in factual situations similar to this example. This practice avoids considerable cost and work. For example, interim accounts would first need to be prepared for each of the three stages so the actuary could undertake a calculation to determine the exempt proportion after excluding the segregated period (in between the two unsegregated periods in that financial year).
Naturally this mismatch between law and practice is unfortunate and may result in unintended consequences.
What are segregated non-current assets
Moreover, further unintended consequences may follow from the ATO view that segregated non-current assets include accumulation accounts: see Law Companion Guideline LCG 2016/8 at footnote three, which states:“ The segregated current pension asset pool supports superannuation income streams (subsections 295-385(3) and 295-385(4) of the ITAA 1997). The segregated non-current asset pool supports accumulation interests (subsection 295-395(2)).”
This would result in many unsegregated funds becoming disqualified from any transitional proportionate CGT relief. The ATO in LCG 2016/8 at [21A], [29C] and  confirm the following:
“38. If a fund is using, and continues to use, the proportionate method throughout the pre-commencement period, it may choose CGT relief for a CGT asset provided:
throughout the pre-commencement period, the asset was not a segregated current pension asset or a segregated non-current asset.”
Thus, the ATO’s LCG is at cross-purposes. It first states the proportionate CGT relief is not available if the fund has any segregated non-current asset and then states a segregated non-current asset is equivalent to an accumulation interest at footnote three. If the ATO’s logic was correct:
- since most unsegregated funds also have some accumulation interest, on the ATO’s own reasoning, the vast majority of unsegregated SMSFs would not be entitled to any proportionate CGT relief, and
- furthermore, an SMSF that is entirely in accumulation mode would require an actuarial certificate.
To confuse things even more, we understand computer software systems and actuarial practice may not be aligned with the above analysis and there may be further differing practices and views at play. Therefore advisers need to carefully check they are applying the ECPI and CGT rules correctly and do not simply accept what is produced by their computer software or actuarial service provider.
Changes from 1 July 2017
From 1 July 2017, both methods of ECPI will be subject to the new requirement that the relevant pension is in retirement phase. TRISs are expressly excluded from being in retirement phase. Accordingly, account-based pensions will be tested for the transfer balance cap, but not TRISs.Additionally, certain SMSFs will be precluded from using the segregated method to determine their exempt income from 1 July 2017. This restriction will apply to an SMSF where a member of the fund has a superannuation interest in tax-free retirement phase and a total superannuation balance in excess of $1.6 million. Note, section 295-387(2)(c) expressly states the total superannuation balance threshold is $1.6 million rather than the general transfer balance cap, so this $1.6 million threshold will not be indexed in the future.
Transitional CGT relief
The transitional CGT provisions in sub-division 294-B of the ITTPA rely on an understanding of both ECPI methods in sections 295-385 and 295-390 of the ITAA 1997. In particular, the CGT relief provisions broadly work on a point in time basis for the purposes of the pre-commencement period, which is 9 November 2016 to just before 1 July 2017.Accordingly, funds that were 100 per cent in pension phase on 9 November 2016 (including funds with members in TRIS phase prior to 1 July 2017) are deemed to be segregated at the relevant time and are potentially eligible for the segregated CGT relief that applies to SMSFs which are under the segregated ECPI method on 9 November 2016. If the segregated CGT relief applies, a cost base reset occurs for elected assets at the time the relevant asset ceases to be a segregated current pension asset of the fund and any notional capital gain is fully disregarded.
In contrast, funds that were not segregated on 9 November 2016 will potentially be eligible for the proportionate CGT relief that applies to SMSFs using the unsegregated method. If this relief is enlivened, the fund will need to account for the non-exempt portion of any notional capital gain on any elected assets in the fund’s 2017 tax return, or opt to defer this notional capital gain indefinitely until such time as the relevant asset is disposed of by the SMSF trustee. One danger, however, based on the ATO view discussed above, is where an SMSF that is unsegregated on 9 November 2016 moves solely into pension phase before 1 July 2017. Under this scenario, the SMSF would be entirely precluded from any CGT relief as the fund had a segregated current pension asset during the pre-commencement period.
Ceasing to be segregated – CGT relief
SMSFs that were segregated on 9 November 2016 must ensure the relevant fund asset ceases to be a segregated current pension asset prior to 1 July 2017.Typically, this is evidenced by a trustee resolution and where a commutation is involved, the ATO in Practical Compliance Guideline PCG 2017/5 has confirmed a commutation can be documented even though the value of the member’s superannuation interests are not available on 30 June 2017, subject to a number of qualifications. This pre-1 July deadline applies to an SMSF to ensure an asset ceases to be segregated prior to 1 July 2017 despite an SMSF having up to the lodgement date of its 2017 tax return to complete the choice in the approved form.
Understanding the ECPI and transitional CGT relief provisions is critical to ensure that SMSF assets are appropriately treated. Hopefully some relief from the complex rules will soon eventuate.
Daniel Butler is a director and William Fettes a senior associate of DBA Lawyers.