If the ability to choose which method to use for an exempt current pension income calculation in an SMSF is legislated, the most expedient way may not be the most effective, writes Mark Ellem.
The changes to superannuation announced in this year’s budget were minimal, compared to previous budgets, and they were all positive. One of the proposals could be considered a response to a call from industry and somewhat supported by the regulator, that is, how a superannuation fund claims fund income as exempt from tax – known as exempt current pension income (ECPI).
The budget announcement was: “The government will allow superannuation fund trustees with interests in both the accumulation and retirement phases during an income year to choose their preferred method of calculating ECPI.”
We have to assume this statement refers to the complexity around the new approach, directed by the ATO, for an SMSF claiming ECPI where it has periods in the financial year where it consists wholly of retirement-phase pensions and for other periods, in the same financial year, a mix of both retirement-phase and non-retirement-phase accounts. For the rest of this article, I will refer to this approach as the “new ATO approach”.
Previously, unless an SMSF consisted wholly of retirement-phase pensions for the entire year or it deliberately segregated fund assets between retirement-phase pension accounts and non-retirement-phase accounts, the industry approach was for the SMSF to use the unsegregated method only. This would be done by applying the actuarially determined ECPI percentage to all eligible fund income for the entire financial year.
The new ATO approach requires identification of eligible fund income during periods of ‘deemed segregation’, separate from eligible income earned during periods where there is a mix of retirement-phase and non-retirement-phase member accounts. Without a specialised SMSF administration and compliance package, this can be quite complex, take considerable time and simply be a nightmare.
If the outcome of the budget announcement is what it appears to be, that is, to give SMSFs the choice to either use the new ATO method or revert back to the prior industry practice, it provides a great opportunity for SMSF trustees, advisers, accountants and administrators to ensure an SMSF’s claim for ECPI is maximised and consequently their tax is minimised.
While we may be initially excited about the prospect of a choice of ECPI methods to minimise fund tax, the actual legislation to deal with this, if we ever see it, may contain provisions limiting this flexibility.
Mark Ellem
Of course, there is a giant assumption here that the relevant one sentence in the budget papers means exactly this: that an SMSF trustee can make a choice and that the choice could be made as part of preparing the annual financial statements and tax return, that is, in retrospect.
As with the introduction of the $1.6 million transfer balance cap, it was initially thought the segregated method would become popular as it would allow high-growth investments to be segregated to retirement-phase pensions and any resulting capital gain on disposal would be exempt from fund tax. However, in the draft legislation the government put a stop to that strategy with the introduction of the ‘disregarded small fund assets’ rule. While we may be initially excited about the prospect of a choice of ECPI methods to minimise fund tax, the actual legislation to deal with this, if we ever see it, may contain provisions limiting this flexibility.
On this point, we expect an SMSF that does have disregarded small fund assets will continue to only be able to apply the unsegregated method to claim ECPI and that the budget announcement does not provide any relief from the current rules and ECPI claim interpretation for these SMSFs.
Assuming you could choose to apply the previous industry practice over the new ATO approach to claim ECPI, I would caution those preparing SMSF financial statements and returns about simply defaulting to this administratively simpler approach. You may end up with the SMSF paying more tax than if the new ATO approach was applied. For example, if the SMSF sold an asset during the period the fund was wholly in pension, any capital gain would be 100 per cent exempt using the new ATO approach. However, if the SMSF chose to apply an ECPI percentage to the entire financial year, you are now turning a 100 per cent exempt gain into partially assessable.
The application of the ‘industry practice’ approach to claiming ECPI may be administratively simpler for the accountant, but the SMSF client is not going to be that happy if they discover their fund has paid more tax than needed. Assuming the budget announcement does, in fact, provide a choice of approach, such funds should be reviewed on a case-by-case basis and discussions had with the SMSF trustee(s) to determine the selected approach for claiming ECPI. It’s really about what’s best for the client rather than what’s easiest for the accountant. Simply defaulting to the previous ‘industry practice’ approach for administration simplicity, when the new ATO approach could be applied and result in a better tax outcome, could be considered at best lazy and at worst negligent.
While the new ATO approach, which has had to be applied since the 2018 financial year, is regarded as complex, it should not be for those preparers of annual financial statements and tax returns for SMSFs that use specialised SMSF administration and compliance platforms. When using such specialised platforms, calculating ECPI and obtaining the relevant actuarial certificate, where necessary, will be an automated process. Where the rules allow for application of either the previous ‘industry practice’ approach or the new ATO approach, such platforms would be expected to provide a comparison of the two to ascertain which approach results in the lower tax outcome.
Let’s consider an example of the two approaches to claiming ECPI.
Bill and Joan are members of their SMSF. At the start of the financial year, Joan, who’s retired, has an account-based pension and no accumulation account. Bill is not retired and has an accumulation account. Their respective member balances are split roughly 50/50. The SMSF does not have any ‘disregarded small fund assets’.
Bill retires from work at the end of December. There’s a party, gold watch, the works. Bill commences an account-based pension on all of his accumulation account on 1 January.
This means that from 1 January, the SMSF is a 100 per cent pension fund, that is, from 1 January the SMSF consists wholly of retirement-phase pensions and is by default a segregated fund, and the income from those assets, from 1 January to 30 June, can be claimed as exempt from 15 per cent income tax without the requirement to obtain a certificate from an actuary.
For the first half of the financial year, as the fund did not set aside specific assets to fund Joan’s account-based pension, the fund would need to claim ECPI under the unsegregated method and obtain a certificate from an actuary to apply to all of the fund’s eligible income derived during the first half of the financial year.
Simply defaulting to the previous ‘industry practice’ approach for administration simplicity, when the new ATO approach could be applied and result in a better tax outcome, could be considered at best lazy and at worst negligent.
Mark Ellem
Using the previous ‘industry practice’ approach, an actuary-issued ECPI percentage would apply to all the fund’s income for the entire financial year. Given that for six months of the financial year, 50 per cent of the fund was in retirement-phase pension accounts and for the other six months, 100 per cent was in retirement-phase pension accounts, you would expect an ECPI percentage of around 75 per cent. Therefore, 75 per cent of the fund’s eligible income for the entire income year would be exempt from 15 per cent income tax. (See tax comparison example.)
While the previous ‘industry practice’ may be perceived as an easy method to adopt for a fund that is 100 per cent in pension for only part of a financial year, it may not result in the best tax outcome for an SMSF. The timing of income received, particularly capital gains on the disposal of a fund asset, if skewed to the period of the financial year the fund was 100 per cent in the pension phase, would warrant the application of the new ATO approach to get the best tax outcome for the SMSF.
Of course, this could all be a moot point and an academic exercise if the proposal does not become legislation. Time will tell and we look forward to the first draft of the budget announcement.
Tax comparison example
Let’s compare the tax under each method. First, Let’s say Bill and Joan’s SMSF derived $100,000 of assessable income in the year that was eligible to be claimed as exempt. If it was derived uniformly throughout the year, the claim for ECPI under each approach would be as follows:
Previous ‘industry practice’ approach
Apply unsegregated method for the entire year:
1 July to 30 June – $100,000 x 75% ECPI = $75,000 ECPI claim
– tax saving of $11,250 ($75,000 x 15%)
New ATO approach
Claim first half using unsegregated method and second half under the segregated method:
1 July to 31 December – $50,000 x 50% ECPI = $25,000
(SMSF was 50% in pension during this period)
1 January to 30 June – $50,000, 100% exempt = $50,000
Total ECPI claim = $75,000 – tax saving of $11,250 ($75,000 x 15%)
So, it’s the same under both. What’s all the hoo-ha about then?
What if included in the $100,000 was a net assessable capital gain of $40,000 from the sale of an asset in the second half of the financial year and the remaining $60,000 was derived uniformly over the financial year?
Let’s recalculate now:
Previous ‘industry practice’ approach
Apply unsegregated method for the entire year:
1 July to 30 June – $100,000 x 75% ECPI = $75,000 (no change)
New ATO approach
Claim first half using unsegregated method and second half under the segregated method:
1 July to 31 December – $30,000 x 50% ECPI = $15,000
(SMSF was 50% in pension during this period)
1 January to 30 June – $30,000 + $40,000, 100% exempt = $70,000
Total claim = $85,000
That’s an extra $10,000 claim for ECPI, which is a reduction to the fund’s tax bill of $1500. Bill and Joan would be happy if their SMSF accountant considered both approaches (again, assuming the resulting law will allow) and applied the approach that resulted in the better tax outcome.
