SMSF trustees considering setting up two funds to manage their transfer balance cap obligations were initially warned the ATO would view this as a tax avoidance move. Michael Hallinan lists some effective arguments that could successfully challenge this interpretation of the strategy.
One very rational response to the introduction of the $1.6 million transfer balance cap was to divide a member’s pension balance between two SMSFs. One SMSF would hold the non-excess portion of the pension balance – this would be the pension fund – and the other fund would hold the excess portion of the pension balance – this would be the accumulation fund. The pension fund would be 100 per cent in pension phase, while the accumulation fund would be 100 per cent in accumulation phase. Presumably, assets would be split between two funds based upon investment criteria such as future capital growth in the pension fund. In determining the exempt current pension income (ECPI) of the pension fund, the non-segregated or pooled method in section 295-390 of the Income Tax Assessment Act 1997 (ITAA) would be used as the pension fund is precluded from using the segregated method.
This very rational response would seem to perfectly implement the policy of the transfer balance cap. However, it has been suggested this perfectly rational response may give rise to the application of the general anti-avoidance provisions of Part IVA of the ITAA. Is there any merit in this suggestion? Will advisers and their clients who implemented the two-fund strategy before 1 July 2017 be exposed to a Part IVA risk?
The suggestion first arose in a newspaper report in April 2017 where a statement was attributed to the ATO that it would take a dim view of members setting up a second SMSF to reduce their superannuation tax bill. It seems the tax office subsequently toned down its response as seen on the ATO website.
The suggestion arises because in implementing the two-fund strategy, transaction costs would be incurred (transferring assets or value from one fund to the other fund and the cost of establishing and operating the second fund), which, in isolation, confer no advantage and in addition, if there has been a discriminatory policy used in selecting the assets to transfer to the second fund, it could be argued the only reason for undertaking the strategy must necessarily be tax driven.
The view taken in this article is “it ain’t necessarily so” (with due apologies to the literary estates of Messrs Gershwin).
Before the main course – some preliminaries. There is no constraint in either the Superannuation Industry (Supervision) Act 1993, the ITAA (both versions) or at general law on whether an individual is a member of one, two or three superannuation funds. Having two superannuation interests is very conventional. Equally, an individual could have a superannuation interest in their own SMSF and a superannuation interest in a larger public offer fund. What is the issue?
A final preliminary: there is no legal obligation on anyone to arrange their affairs in such a manner to maximise the amount of tax payable. Equally, not arranging your affairs to maximise the amount of tax payable is not a situation to which Part IVA applies.
"The two-fund strategy can be used to clearly separate superannuation interests, which permits each super interest to have a different post-death destination."
In very basic terms, for Part IVA to apply there must be a scheme, there must be a tax benefit and a tax benefit purpose. All three elements must be satisfied for Part IVA to apply and if it does apply, there is one defence being the ‘express election’ defence.
Whether Part IVA applies
While the term scheme is so widely defined it is almost impossible for any course of conduct not to constitute a scheme, so the existence of a scheme will not be doubted. The identification of the scheme is critical for two reasons. The first is that the tax benefit must have been obtained in connection with the scheme. The second is that in determining whether there is a tax benefit purpose, the purpose must be objectively inferred from the scheme.
The relevant scheme involves the establishment and operation of a second fund and the decision that specific assets be either retained in the current fund or transferred to the second fund.
Once the scheme has been identified, then there must be a tax benefit arising from the scheme. Presumably, the tax benefit is derived by the trustee of the pension fund as capital profits from growth assets in this fund will enjoy a 100 per cent ECPI rather than a reduced ECPI percentage had there been no division of the assets.
Given there is an identified scheme and a tax benefit arising from the scheme, the final element is that the sole or dominant purpose of the scheme is the enabling of the tax benefit. The sole or dominant purpose must be objectively inferred from eight specified criteria. The purpose could be that of the trustees of the fund or the members.
While there is a defence to Part IVA – in that a tax benefit arises solely from an action permitted by a particular tax provision – the two-fund strategy does not involve any relevant particular tax provision.
Is there a tax benefit?
Is it possible to argue the two-fund strategy provides no tax benefit? There were a number of possible responses to the impact of the transfer balance cap. These include transferring the excess pension value to a public offer fund, withdrawing the excess pension value from the superannuation system and investing the excess in the member’s own name or investing the excess as part of a discretionary trust. Simply doing nothing is one response, but not the only response.
Whether a tax benefit has been obtained in connection with a scheme depends on whether the tax benefit (that is, non-inclusion of a realised capital gain) would have occurred (or might reasonably be expected to have occurred) if the scheme had not been carried out. This comparison with an alternative reality is required by section 177C(1) of the ITAA. The operative of the alternative reality test was materially modified by section 177CB (which provision applies from 16 November 2012) in a manner adverse to the interests of the taxpayer.
The alternative reality test as modified by section 177CB(3) requires the alternative reality be reasonable to carrying out the scheme. It seems eminently arguable that an alternative reality to the scheme would be to transfer the excess value to a public offer fund, to transfer the excess to the member or to transfer the excess to a discretionary trust. These alternative realities may survive the limitations imposed by section 177CB(4) (in particular (b)) as the alternatives were open to the trustees and member. In particular, in relation to the first alternative, the excess value remains within the superannuation system and is on the accumulation side of a fund not controlled by the member. In relation to the other two alternatives, they are a rational response to the regulatory uncertainty of superannuation.
Is there a tax benefit purpose?
The final element will be satisfied if it would be concluded, having regard solely to the eight matters listed in section 177D(2) of the ITAA, that any person carrying out the scheme (for example, the trustees or the members) did so for the sole purpose of obtaining the tax benefit. If it can be concluded there were two or more purposes, then the final element will be satisfied if the dominant (that is, the ruling, prevailing or most influential motivating factor) purpose of one of the relevant actors was a tax benefit purpose.
There seems to be a stronger case to argue it cannot be automatically inferred from the listed matters that the two-fund strategy is solely driven by a tax benefit purpose. Those other reasons could include succession planning, quarantining of investment risk, investment strategies and membership changes.
The two-fund strategy can be used to clearly separate superannuation interests, which permits each super interest to have a different post-death destination. In the case of a blended family, the pension interest could transfer to the second spouse while the accumulation interest could be transferred to the children of the first marriage. The second spouse could be involved in the pension fund but not the accumulation fund, while the children could be involved in the accumulation fund but not the pension fund. The beneficiaries of the relevant interest could have control over their respective interests. Complete separation of the interests into separate funds, like good fences, may create neighbourly relations between the second spouse and the children of the first marriage.
The two-fund strategy is also an effective means of assisting children to avoid excessive fees associated with public offer funds. The children could be admitted as members of the accumulation fund thereby permitting their super guarantee contributions to be invested in a cost recovery environment and not be eroded by unnecessary insurance costs. The children by being appointed as trustees of the accumulation fund may thereby gain experience in investing and operating a superannuation fund.
Asset risk quarantining
Some tangible assets have risks in addition to purely financial risks, such as real estate where non-financial risks such as ‘slips and falls’ by members of the public on retail property owned by the fund or contamination risks arising from past use of land can occur. While these risks may be addressed by insurance, the legal liability for compensation or remediation is that of the individuals or legal entity which comprise or is the trustee of the superannuation fund. If the insurance cover does not respond or is inadequate, the shortfall is the liability of the trustees. Generally, the trustees would have a right of indemnity against all the assets of the superannuation fund irrespective of whether the asset giving rise to the liability is held on the pension or accumulation side of the fund.
Investment strategies – business critical assets
In separate funds different investment strategies may be more readily implemented and altered as the circumstances require. This is particularly relevant where a business critical asset is held in the superannuation fund. Holding such an asset in the accumulation fund may be more suitable than holding the asset in a pension fund or a mixed fund with both pension and accumulation interests as the minimum pension payment requirement will eventually exceed the net yield of the business critical asset, giving rise to a cash-flow issue that may require the sale of other assets.
Admission of other members
Having separate funds will also accommodate the introduction of other members with the retention of control and privacy as to the pension interests. Consider the situation where the parents are the only members of the pension fund, while the parents and children are the members of the accumulation fund. The parents will retain privacy and control in relation to their pension interests as they are the only members and trustees. The children can be admitted to the accumulation fund for any number of reasons – as a means of holding their superannuation guarantee contributions to prevent balance erosion as would occur in fee-based funds such as public offer funds; if the accumulation fund holds business critical assets, they could be admitted to the accumulation fund as part of the business succession plan.
As the words of the song say “it ain’t necessarily so” that the only reason to implement the two-fund strategy is a tax benefit reason. It would be a different matter if, after the separation of the two funds, each fund then would sequentially become the pension fund and the accumulation fund. However, the two-fund strategy is a once-off separation of assets to support pension liabilities and only pension liabilities, while the remainder assets support and only support accumulation liabilities.